It was all a bad dream. That, at least, is one interpretation of markets’ view of Liz Truss’s short and chaotic premiership. The pound stood at $1.15 against the dollar when she took office 44 days ago and was $1.13 soon after her resignation – down a bit, but most things are against the US currency.
Over in the gilt market, the yield on 10-year government IOUs, the usual yardstick of the country’s medium-term cost of borrowing, is a shade under 4%, which doesn’t sound so bad when inflation is 10%, the rest of the world is laughing at your governing party and a clear-the-air general election could still be two years away.
The appearance of relative calm in markets can be explained. The power of bond vigilantes to squash madcap economic adventures has just been demonstrated – not that anybody (apart from Truss and Kwasi Kwarteng, obviously) ever doubted it. The definition of fiscal responsibility has narrowed.
Meanwhile, the Bank of England, the body that markets understand best, emerges with its authority enhanced. It saved the government from a mess of its making by halting the run on pension funds. There’ll be less talk in future about reviewing its mandate (though a postmortem on why Threadneedle Street didn’t spot the unexploded bomb that was liability-driven investment strategies really deserves to happen). And the Office for Budget Responsibility, which sadly never got a chance to savage Trussonomics, has acquired god-like status. The show of institutional strength makes international investors feel more comfortable.
Appearances, though, can also be deceptive. The dial would turn immediately, no doubt, if the Tories choose anybody other than Rishi Sunak as the next prime minister – and all bets are off if Boris Johnson returns to heighten hilarity abroad.
Nor can one say that the “political risk premium” has evaporated from UK assets. ING’s economists put it at 0.5% in 10-year borrowing costs versus the US and Germany – it may not sound much, but it ricochets through the economy for households and businesses. “The old adage, that it takes years to build confidence but only one day to destroy it, applies here,” they say.
Therein lies the true cost of the Truss detour. The next administration will feel compelled by fear of the markets to overdo fiscal restraint. Jeremy Hunt, in the course of a week as chancellor, has reversed two-thirds of Kwarteng’s tax measures, but the remaining portion of the fiscal hole – as much as £40bn – is scheduled to be filled by spending cuts.
In another world, a UK government could reasonably have expected extra borrowing to smooth the passage to the other side of recession, but the scope for manoeuvre is plainly less than it was. As Paul Dales, chief UK economist at Capital Economics, puts it, “in just a few weeks fiscal policy has swung from being ultra loose to less loose to outright tight”.
The cost of restoring market credibility, then, looks certain to be cuts, a return to a version of austerity and a harder downturn than would have been the case. The consensus among economists is now a 2% contraction in GDP; after 12 years of little growth, it will feel worse. When she entered office, Truss vowed to make the recession shorter and shallower – in all likelihood, she has made it deeper and longer.
The only small consolation is that the Bank may put up interest rates by less than previously thought, though that outcome is not guaranteed. Nor is it really a consolation. Here’s ING’s analysis again: “The Bank essentially faces a choice between hiking aggressively and baking in the ultra-high level of mortgage and corporate borrowing rates, amplifying the depth of a recession through the first half of next year – or undershooting market expectations, at risk of a weaker pound and more imported inflation.”
The analysts think it’ll be the latter (and a dovish speech on Thursday by Ben Broadbent, one of four deputy governors at the Bank, supports that view), but it’s a choice of two evils. There are no good options.
Truss, we can conclude, put all the faults in the UK economy on full international display and made it harder for her successor to find remedies that do not involve a crashing recession. That is quite a legacy from six weeks in office. Markets can brush it off, but the bill for the doomed experiment is yet to arrive for the rest of us.
