The BoE did not respect free market rules – GIS Reports
Why did British Prime Minister Truss’ fiscal policies meet with such outcry and why did the BoE find it necessary to oppose them?
In a word
- An attempt to restore the conditions for economic growth has caused an outcry
- The reaction of the markets and the central bank condemned the British government
- The BoE followed the steps of the ECB’s destructive monetary policy
Elizabeth Truss became Prime Minister of the United Kingdom in early September. Soon her reputation was in tatters and she resigned under pressure on October 20. What went wrong and what opportunity did the Bank of England (BoE) lose in the drama?
In short, soon after Ms Truss took office, she and Chancellor of the Exchequer Kwasi Kwarteng launched a package of free market measures focusing on tax cuts, deregulation and preventing certain categories of social benefits to keep up with inflation. Salaries of civil servants would also be severely reduced in real terms.
Prime Minister Truss had been clear on his vision of what needed to be done weeks before his appointment. Yet many commentators and parliamentarians were surprised when she once spoke at 10 Downing Street. As a result, his party let down the new prime minister, the BoE and the International Monetary Fund openly criticized his measures, the financial markets were unhappy, and public opinion (including most of the press) was outraged.
A few days after the reaction of the financial markets, the Prime Minister admitted that his proposal to reduce the top tax rate on high incomes by 5% was politically inappropriate. The overthrow might have given the new government a second chance, but it was probably too little too late. Financial markets almost panicked, and the BoE stepped in and bought many UK government bonds, many of which were on the balance sheets of UK commercial banks, pension funds and insurance companies. So while the yield on the UK 10-year gilt initially rose from 3% (early September) to 4.6% (end September), it fell back to 4% in early October and was still there when Ms Truss stepped down.
Her abrupt resignation made it clear that she had little control over her party and had not sufficiently prepared the ground.
During the same period, the pound fell from $1.15 to $1.07 but recouped its earlier losses and was around $1.13 when the prime minister resigned. Curiously, many neglected to point out that interest rates had already risen in previous months (they were below 1% in January 2022) and that the pound had steadily fallen (from $1.35 in January 2022). One might suspect that Mrs. Truss was a convenient scapegoat.
There is no doubt that September was a disastrous month for the new Prime Minister and his decision to sack Chancellor Kwarteng was seen as a sign of weakness. Indeed, it was not enough for the leader to stay afloat, and her abrupt resignation made it clear that she had little control over her party and had not sufficiently prepared the ground.
Simply put, Ms Truss was brave and took her job seriously, but it turned out that many Tories had different views on her mission and she underestimated the reaction of the BoE. As a result, the ambitious program was abandoned.
Growth, not redistribution
The sketch of the scenario that will take shape in the coming weeks will depend on the evolution of the three major players – the new Prime Minister, the Conservative Party and the BoE.
Ms Truss was right to say that growth is the best way out of a crisis, rather than money printing, inflation and redistribution. Although it sounds like a platitude, too many people seem to have forgotten that over the past two centuries, global gross domestic product (GDP) per capita has increased nearly 14 times (and population more than seven times) thanks to technological breakthroughs and the efforts of entrepreneurs, not as a result of monetary manipulation, deficit spending and recovery and resilience plans.
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Indeed, such growth has made everyone better off, including the poor, and has placed the world in a much better position to deal with crises. Yet new Chancellor of the Exchequer Jeremy Hunt has backtracked on Ms Truss’ battle plan. Its basic message was that it would operate with the BoE to ensure stability, ie the status quo until Downing Street had a new tenant.
It seems obvious that the Conservative Party is not willing to oppose the BoE and the financial community – banks, insurance companies, investment funds and pension funds. However, it is far from clear that this will be enough to avert disaster for the ruling Conservatives in the next election.
Facts and figures
At the end of October, polls on voting intentions showed a lead of 30 percentage points for the opposition Labor Party. The British economy is doing relatively well. Although its GDP is still (slightly) below its pre-Covid level and has stopped growing, the IMF projects that in 2022 the country’s growth will be above 3% (data for the euro zone is 2 .6%). Moreover, the unemployment rate is around 3.5% (6% in the EU) and the debt/GDP ratio (96%) is not much higher than that of the EU (88%). However, the prospects for 2023 are not encouraging: 0.5% GDP growth for the United Kingdom (and 1.2% for the euro zone). The Organization for Economic Cooperation and Development (OECD) is even more pessimistic.
High inflation will not help matters: consumer price inflation on an annual basis is currently around 10% and expectations for 2023 are above 6%. Whoever is in power will likely be blamed, regardless of their politics.
Will the new government be able to make progress and perhaps appreciate at least some of Ms. Truss’ vision? Three major obstacles stand in the way of free market reforms.
One comes down to a delay in time. Structural reform aimed at stimulating economic growth does not produce immediate results. A business environment that encourages entrepreneurs to engage in new ventures and expand productive capacity is essential. However, investors and entrepreneurs need time to find the new context credible and unlikely to change again in a few years – especially if the Tories shed their identity as free market advocates and polls show Labor will prevail. .
Second, Ms. Truss’ experience underscored that deep cuts in public spending are essential to prevent the budget deficit from growing intolerably before growth broadens the tax base and generates adequate revenue. The deficit was almost 15% of GDP in 2020/2021; before the last leadership crisis, it was expected to fall to 6% in 2021/2022.
The third set of problems concerns the role of the BoE, which naturally worries about inflation but also about the fragility of vital financial players. Forced to choose between monetary stability (inflation) and financial stability (avoiding heavy losses for banks and pension funds), the bank opts for the second and avoids major reforms.
Eventually, it is feared that 10 Downing Street will become a branch of Threadneedle Street. The BoE’s tolerance for high taxation and its fascination with market manipulation and regulation will not make banks and pension funds healthier. The inflationary problem can get worse: expectations about future price increases can quickly deteriorate, interest rates rise faster than expected, and volatility escalates. As a result, growth will be stifled; pressure groups will be increasingly active in demanding subsidies and the budget deficit will come under further pressure.
The irony is that BoE Governor Andrew Bailey will likely become the White Knight and the new Prime Minister as his political executive. Admittedly, Ms Truss was an imperfect copy of Margaret Thatcher, Britain’s ‘Iron Lady’ Prime Minister (1979-1990). Having refused to join the Eurozone, the UK had a great opportunity to contain inflation early on. Following in the footsteps of European Central Bank leaders Mario Draghi and Christine Lagarde, however, BoE governors lost that opportunity, and Prime Minister Truss lacked the political power to undo the damage and defuse the panic. .
It’s hardly surprising: Confronting the BoE in the 2020s is tougher than going after the unions, as the Iron Lady did in the 1970s. Those who followed Ms Truss didn’t even not tried.