On 25th October 2022, Liz Truss, the former Prime Minister of the United Kingdom, resigned from office – setting a record for the shortest-served Prime Minister of the United Kingdom. In the passage, let us examine closely at her government’s economic policies, namely Energy Price Guarantee and Mini-budget plan, and their impacts on the British economy. And finally, reflecting the flaws in her policy leading to her resignation after merely 45 days.
The General Situation and the Bank of England
Since 2022, The world was entrapped into an energy crisis due to the on-going Russian-Ukraine war, with fossil energy hitting ever-high prices. Among the globe, the European countries suffered the most out of this. Britain has seen high-inflation since April 2022, and in July the inflation rate was as high as 10.1%, reaching a 40-years high. The Bank of England soon took counter actions, issuing 7 consecutive interest rate rises, to suppress the surging inflation rate. Although this will suppress the short-term economic growth as the increase in interest rate will reduce the currency liquidity which will discourage spending and investment, still it is necessary in the moment.
Growth, Growth, Growth...
Britain warmly welcomed the new Prime Minister-Liz Truss on 6th September who succeed from Boris Johnson-the pervious British Prime Minister. Like every other new leader, Liz Truss urgently wants to carry out her ambitious plans to improve the circumstance. And her goal was to “Pave the way to Economic growth”, in other words, to boost the British economy and achieve greatness.
Shortly after she was appointed, she implemented the Energy Price Guarantee that tries tackle the problem of growing energy price endured by all the British household. The goal was to mitigate the cost of living of households, and to cap the average household energy bill at £2500 per year through government subsidy. The plan was undoubtedly well-intentioned, but the problem occurred on the £100 billion extra cost the state needs to bare, further jeopardizing the weak economy.
On top of that, the most controversial mini-budget plan, also known as the Growth Plan, was announced on 23rd September. The plan raised a radical cut in taxation, lowering the basic rate of income tax from 20% to 19% and adjusting the top income tax from 45% to 40%. The mini-budget plan was estimated to reduce Treasury revenue by £45 billion in 2026/27, which also makes it the most radical tax reduction plan in the past 50 years
Clearly Liz Truss’s top priority was to stimulate the economy, nevertheless, her methods were radical and mistaken. The Energy Price Guarantee and the mini-budget plan all aim to boost the economy through direct government subsidy and tax reduction to encourage spending and investment, and it is what countries will do when they want to achieve economic growth. However, the British economy was in a state of high inflation, and in fact, the unemployment rate in United Kingdom is quite low, around only 3 percent. Therefore, Truss’s plans not only won’t inspire any production capacity and employment in the short run, but also evoke even significant inflation. Nonetheless, Liz Truss seems to hold different opinion and that’s why she implemented these policies regardless of the objections coming from mainstream academia.
Aside from the mistaken priority, Truss’s plans possess their own flaws. First of all, the tax reduction focused on the wrong tax brackets. The mini-budget plan reduced the 45% income tax rate charged on those who earns over £150,000 per year to 40%, while reducing only 1% of income tax on those who earns between £12,570 to£ 50,270 per year. Basically, the richest in the country enjoyed the biggest cuts in tax, saving up to 10 thousand pounds per year in the sake of the reduction in tax. On the other hand, those who suffered the most from the rising living cost benefited little from the plan. Second of all, the Energy Price Guarantee and the mini-budget plan were all too expensive. The combined extra £145 billion expenditure for the British government is no doubt unaffordable, as a result the already debt-ridden British government has to borrow more, and later we will see how this evolved into a catastrophe.
The Market’s Response
Liz Truss’s bold policies were poorly received by the public, the former US Treasury Secretary Larry Summers’s comments on policies were “utterly irresponsible”. If the public’s reactions were still euphemistic, then the market’s reaction is a total disaster. The most secured asset, the UK Treasury Bonds, were being sold in a panic, in two days’ time, the yield on 10-year Treasury note soared from 3.45% to 4.5%. Although 1% change seems negligible, note that normal fluctuation is only about 0.002% to 0.003% per day. Therefore, in theory, such dramatic increase is without exaggeration impossible, but real life is often more unrealistic and illogical.
Let’s move on to the exchange rate. By 26th September, merely three days after the tax reduction plan was announced, the British pounds fell from 1.08 to 1.03 against US dollars, breaking the lowest record British pounds ever get to against US dollars. A 5% fall in the exchange rate, especially for such a huge currency like the pounds, is undoubtedly a devastating dive. More importantly, the positive relation between the exchange rate and the national bonds’ interest rate was broken, an obvious sign of the lost confidence of the market towards the United Kingdom.
Despite all the terrible losses Britain experienced, the almost evaporated British pension funds is what the most severe outcome. According to the data published by the UK Treasury in 2018, on average, overly 40% of private asset are made up by pensions. For pension funds, they prefer investments that are stable, low risked, so the national bonds that are issued by the government are the most ideal form of investment as it perfectly suits the demand of pension fund investors. But low risk also means low return, thus, pension funds need other measures to increase their return. Liability Driven Investment (LDI), a beat between pension funds and investment banks about the change of interest rate in order to offset the risk, and Treasury Repo, a transaction of securities which buyers pledge to resell back to seller, are two commonly used tools to lower pension funds risk and increase return.
The two tools work totally fine under normal situation, but now as the British economy went into chaos, these two tools became the chief reason why British pension almost collapse. Both LDI and Treasury Repo requires collateral as a form of insurance in transaction, and in times when bonds depreciate, more collateral are needed. Therefore, in current circumstance, when tax reduction plan is in action causing bonds to fall and interest rate to rise, pension funds are obligated to provide more collaterals. When pension funds used up their cash to pay collateral, selling high liquidity national bonds will be their next movement. Thus, a vicious cycle is created as selling more bonds will further push up the interest rate and even more collaterals are needed. And this was the prominent reason behind the panic selling of UK Treasury Bond.
Resolution
In short, Liz Truss’s policies that attempted to promote the British economy achieved just the opposite. The market wholly lost its confidence towards Britain, resulting in the tremendous decline in the UK Treasury Bond, Pound’s exchange rate and British stock market. To save the tottering economy, on 28th September, the Bank of England announce to spend 65 billion pounds to buy unlimited amount of bonds for 10 days. The tax reduction plans that cut the tax for the richest was soon withdraw by Liz Truss and her new minister of Finance was also dismissed. Shortly after, Liz Truss was too resigned from the position, making her the quickest Prime Minister. Liz Truss left 10 Downing Street, but the trauma she done to the British economy lingers, giving the next prime minister a huge problem to solve.