Once lost, economic credibility is hard to regain. Can the Tories ever recover?

Once lost, economic credibility is hard to regain. Can the Tories ever recover?

Even a U-turn might not be enough to save the government after this self-inflicted crisis, writes Ed Conway

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sunday october 2 2022

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ED CONWAY

Once lost, economic credibility is hard to regain. Can the Tories ever recover?

Even a U-turn might not be enough to save the government after this self-inflicted crisis, writes Ed Conway

Ed Conway

Saturday October 01 2022, 6.00pm BST, The Sunday Times

Try for a moment to put yourself in the shoes of Liz Truss’s advisers. You have been waiting for this moment your entire political career: a rare opportunity to turn the economic dial and introduce bold liberal reforms to the UK economy. You watched with horror as your political colleagues allowed the tax burden to balloon to historic levels. You observed them borrowing astounding amounts of money at incomprehensibly low interest rates. You fizzed with frustration as the Bank of England kept pumping cash into the economy long after it was necessary. And now your time has come.

You were well aware that markets rarely like surprises, so you were transparent for months about the most expensive parts of your plan: the cancellation of the corporation tax cut, the reversal of the national insurance increase. You pre-announced your energy price guarantee and the markets hardly blinked. You kept a few cheeky rabbits in the hat: the abolition of the 45p tax rate and an early cut in the basic rate of income tax. But these last two were piddling policies, in fiscal if not political terms: a few billion pounds apiece. Not enough, surely, to spook investors.

You leaked the news that this time there would be no Office for Budget Responsibility (OBR) forecasts. Rishi Sunak hadn’t needed any as chancellor when he introduced the furlough scheme; why should you have them with your emergency growth package? What could possibly go wrong . . . ?

Roll on a few days and you are bunkered up in Downing Street, trying, above all else, to comprehend what happened. You wanted to go for growth, introducing the very reforms — improving planning, increasing allowances on business investment and opening the doors to more immigrants — that investors had called for. Now, in an obscene irony, the market reaction itself carries such costs that your growth plan will almost certainly undermine Britain’s prosperity for years.

The first step is to glean what is happening, but all your contacts in foreign exchange markets tell you is that the response simply doesn’t add up. The collapse in the pound and the rise in government bond yields is of such an order that it surely cannot be linked to any of the measures in the mini-budget: not the 45p tax, not the income tax or the abolition of the bonus cap, which was trailed long before the announcement. They assure you that the wild newspaper headlines blaming you for everything make no logical sense. So you scramble for other explanations: it must be the gyrations of US financial markets, the impact of Russia’s invasion of Ukraine, the symptom of perverse trading strategies by pension funds, fears of a Labour government . . .

Except there is another explanation, one much more plausible yet too horrifying to contemplate. This explanation has no grounding in economics, numbers or cause and effect. It is not tied to any single policy in the mini-budget or any single misstep during the campaign, yet the more you contemplate it — if you can bear to contemplate it — the plainer it is: this is a credibility crisis.

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sunday october 2 2022

You are reading this article for free.

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ED CONWAY

Once lost, economic credibility is hard to regain. Can the Tories ever recover?

Even a U-turn might not be enough to save the government after this self-inflicted crisis, writes Ed Conway

Ed Conway

Saturday October 01 2022, 6.00pm BST, The Sunday Times

Try for a moment to put yourself in the shoes of Liz Truss’s advisers. You have been waiting for this moment your entire political career: a rare opportunity to turn the economic dial and introduce bold liberal reforms to the UK economy. You watched with horror as your political colleagues allowed the tax burden to balloon to historic levels. You observed them borrowing astounding amounts of money at incomprehensibly low interest rates. You fizzed with frustration as the Bank of England kept pumping cash into the economy long after it was necessary. And now your time has come.

You were well aware that markets rarely like surprises, so you were transparent for months about the most expensive parts of your plan: the cancellation of the corporation tax cut, the reversal of the national insurance increase. You pre-announced your energy price guarantee and the markets hardly blinked. You kept a few cheeky rabbits in the hat: the abolition of the 45p tax rate and an early cut in the basic rate of income tax. But these last two were piddling policies, in fiscal if not political terms: a few billion pounds apiece. Not enough, surely, to spook investors.

You leaked the news that this time there would be no Office for Budget Responsibility (OBR) forecasts. Rishi Sunak hadn’t needed any as chancellor when he introduced the furlough scheme; why should you have them with your emergency growth package? What could possibly go wrong . . . ?

Roll on a few days and you are bunkered up in Downing Street, trying, above all else, to comprehend what happened. You wanted to go for growth, introducing the very reforms — improving planning, increasing allowances on business investment and opening the doors to more immigrants — that investors had called for. Now, in an obscene irony, the market reaction itself carries such costs that your growth plan will almost certainly undermine Britain’s prosperity for years.

The first step is to glean what is happening, but all your contacts in foreign exchange markets tell you is that the response simply doesn’t add up. The collapse in the pound and the rise in government bond yields is of such an order that it surely cannot be linked to any of the measures in the mini-budget: not the 45p tax, not the income tax or the abolition of the bonus cap, which was trailed long before the announcement. They assure you that the wild newspaper headlines blaming you for everything make no logical sense. So you scramble for other explanations: it must be the gyrations of US financial markets, the impact of Russia’s invasion of Ukraine, the symptom of perverse trading strategies by pension funds, fears of a Labour government . . .

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Except there is another explanation, one much more plausible yet too horrifying to contemplate. This explanation has no grounding in economics, numbers or cause and effect. It is not tied to any single policy in the mini-budget or any single misstep during the campaign, yet the more you contemplate it — if you can bear to contemplate it — the plainer it is: this is a credibility crisis.

Of all the economic forces in the world, credibility is especially mysterious and ineffable. We live in an era when currencies are not valued in a certain weight of gold or silver but are worth whatever people think they are worth. This is one of those mind-bending truths that is best not to spend too much time considering — in much the same way as it is best, on a transatlantic flight, not to ponder that mathematicians still cannot agree on a formula to explain what keeps planes aloft.

Once upon a time, Britain’s credibility came from its economic might and its management of the gold standard. Today, it probably derives from boring institutions that went out of fashion years ago: the Bank of England and its boring inflation target, the Treasury and its boring mandarins, the rule of law, a history of creditworthiness, long-dated bonds and boring fiscal rules, as well as bodies such as the OBR. I say “probably” because there is no definitive formula. But somehow this cocktail of components exerts a magical effect upon Britain’s currency and its bond prices, making them worth more than the sum of their parts.

The best example of this dates back to May 6, 1997, the day Gordon Brown, chancellor at the time, gave the Bank of England independence to set interest rates. In one fell swoop, Britain’s cost of borrowing fell by half a percentage point. That might not sound like much, but it was a financial boost that in hindsight helps explain a decent chunk of Britain’s prosperity ever since. Those lower borrowing costs helped businesses and households invest even more in the coming years. It was a credibility windfall.

This all matters because had we made decisions purely on the basis of economic data, this country would have been shunned by many of its investors years ago. We have a large and inexorably growing current-account deficit. Every year for as long as anyone can remember, the government spent more than it generated in taxes. Our productivity was low and our demographics were worsening, and rather than reducing trade frictions, we recently divorced our main trading partner. But somehow the plane kept on flying. We carried on borrowing and investors carried on lending.

The reason I’m going on about all this is mainly to underline that credibility is one of those vague but important forces that is both difficult to quantify and, more ominously for the Truss team, difficult to put back together again.

Truss’s market contacts are right that there is no straightforward explanation to be found in the fiscal numbers. In practice, it was probably a bit of everything: the scale of the giveaway, the sidelining of the OBR, the firing of experienced Treasury boss Sir Tom Scholar and badmouthing of the Bank of England, the vague promise of more tax cuts over the weekend. Somehow this new government achieved in a few days something that none of its predecessors managed in decades: it inadvertently dismantled the credibility buffer helping to keep the markets aloft.

The symptoms are precisely what you’d expect from a credibility crisis: a falling currency as investors think twice about putting their money into the country, and rising interest rates as they demand more return for holding your (suddenly more risky) assets. Those rates begin to trickle through the economy — into mortgages and business loans — in a perverse reversal of that credibility windfall we enjoyed from 1997 onwards.

The chain reaction of higher rates fans out through asset markets, causing bumps along the way, though quite what those bumps are is hard to predict. At the beginning of last week, few would have anticipated the near-default of swathes of pension assets. But the bigger picture is not just of a vulnerable, brittle financial system but something else: a slow, insidious spiral that eventuates, years later, in a country that is comparatively poorer. A vicious spiral rather than the virtuous circle of growth the “fiscal event” was supposed to create.

One can well understand why no one in Downing Street much wants to contemplate this, for the consequences, both personal and institutional, are stark. For one thing, the logic of a credibility crisis would be that Trussonomics, or whatever you want to call it, would be effectively dead. Not, it’s worth saying, because the ideas were necessarily wrong: lurking at the heart of the mini-budget, alongside the more controversial tax policies, was a set of interesting, if vague, proposals to reform planning and make Britain somewhat more dynamic. But no one wants to talk about them now, except for the prime minister and some of her acolytes. At this juncture, though, lecturing investors about supply-side reforms, important as they may be, is a little like tending to the topiary in your front garden even as the house behind you goes up in flames.

In a credibility crisis, spending much time dwelling on the merits of your tax plans is not just a waste of time; it is a dereliction of duty. Instead, you need to do whatever you can to show you are serious about rebuilding confidence.

What that entails is not straightforward. Since it’s not altogether clear which part of the mini-budget — if any of it — most revolted investors, it’s not clear whether changing much of it would make much difference. The International Monetary Fund (IMF) insinuated this week that reinstating the 45p rate would help, but given that it only accounted for a few billion pounds, that might also be missing the point.

The government can belatedly embrace the OBR, but this is easier said than done, since November’s OBR report will paint an utterly grisly picture of the public finances unless the government finds some money to finance the £45 billion of extra borrowing it committed to just over a week ago. But here it runs into even more problems, because the market crisis has pushed interest rates on its debt even higher, threatening to add as much as £20 billion to the debt interest bill. So the black hole in the public finances looks even bigger.

If this sounds a lot like a mess that’s because that’s precisely what it is. When credibility evaporates, everything gets tougher and more expensive. And since credibility is such an enigmatic force, no one knows precisely how to rebuild it.

These crises rarely end well for those who initiate them: they generally result in the departure of some or all of the personnel. Sometimes the protagonists survive, but not before having to throw out most of their policies.

One of the more hopeful examples concerns François Mitterrand, the socialist French president whose initial attempts to reform the economy in the early 1980s prompted successive devaluations of the franc. Within a couple of years he was forced into an enormous and humiliating austerity programme. But he survived. Just. He won a second term in 1988. Most of the others ended in oblivion.

Ed Conway is economics and data editor of Sky News