Opinion – Paul Krugman: How Liz Truss did so much damage in so few days

Liz Truss, who became the UK’s prime minister less than a month ago, may have set a political speed record. She is certainly not the first leader who has been forced to make a political about-face in the face of adverse market reactions. But announcing an economic program and then abandoning its central girder just ten days later is something special.

And we of the center-left can be forgiven for taking a certain pleasure in disgrace, I think. Conservatives constantly warn that progressive policies will be punished by “bond watchers,” who they say will raise interest rates in anticipation of any increase in public spending.

Such warnings often turn out to be wrong. In Britain, however, the bond watchdogs really showed up: interest rates soared after the Truss government announced its economic plans. But the market wasn’t reacting to overspending; was reacting to irresponsible tax cuts.

That said, the simple story – Truss proposed policies that would increase the budget deficit and fuel inflation, and markets reacted by pushing interest rates up and the pound down – misses out on much of what actually happened. It was simultaneously more and less than a matter of dollars and cents (or pounds and pence). Rather, it was primarily a government wasting its intellectual and moral credibility.

How big is the tax cut that Truss proposed? She and her advisers announced their unbudgeted policy, which contributed to the market’s loss of confidence. However, there are independent estimates; For example, the Resolution Foundation, a British analyst group, estimated Truss’ tax cuts at £146 billion over the next five years, which would be about 1% of projected GDP over the same period. . This isn’t trivial, but it isn’t huge either. And the specific tax cut that was just dropped, a reduction in the maximum tax rate, was only part of that total.

So why was the market reaction so fierce? In part because Truss and Kwasi Kwarteng, the Chancellor of the Exchequer, justified their actions with the much-discredited claim that lowering higher tax rates would give a huge boost to economic growth. This raised doubts about their competence and indeed their connection to reality; It’s never good when economists at big banks declare that a country’s ruling party has become an apocalyptic cult.

Questions about Truss’ assessment were reinforced by her lack of sense of timing. Right now, ordinary Europeans, including the British, are facing hard times, largely as an indirect consequence of Russia’s invasion of Ukraine. The Ukrainians, incredibly, seem to be winning the war; it does not diminish its value to say that Western weapons played an important role in this success. So Vladimir Putin tried to pressure the West by cutting off natural gas flows.

This is a huge adverse economic shock for Europe, probably bigger than the oil shocks of the 1970s. Governments are trying to limit the hardship caused by rising energy bills. But all of Europe – again, including Britain – faces something like the economic equivalent of war. (The United States is much less affected, although natural gas prices have also gone up here.) And, as in wartime, government policies need to promote a sense that the people are all in this together.

Right now, tax cuts for the rich, who are already less affected by higher energy prices than people with lower incomes, sends the message that only the small will face difficulties. This message is especially toxic because the British public is already in an uproar over cuts in public services, especially healthcare, and wants to see taxes go up, not down, to subsidize more. And it’s hard to govern effectively when you’ve angered most of your nation.

There was one more factor in the market turmoil created by Truss’s proposals, which magnified the effects of the loss of credibility. It turns out that British pension funds, which hold many government bonds, have tried to reduce risk with complex financial strategies that require them to put in extra cash when interest rates rise and bond prices fall. When interest rates spiked, pension funds couldn’t raise enough cash in the short term — and that threatened to force the sale of bonds that would drive rates even higher. The Bank of England’s emergency intervention limited the damage, but the episode added even more anxiety.

And yes, with interest rates rising almost everywhere, one has to wonder if there are other financial crises waiting to happen. The British bond collapse was probably exceptional, but no one who remembers 2008 can help but feel a little nervous.

But back to the Truss disaster. As I said, the wild market reaction to the new prime minister’s plans was caused by more than money. In difficult times, leaders need to be seen as realistic and fair. But what Britain has achieved is a leader who seems to live in a fantasy world and is oblivious to concerns about social solidarity. And it’s going to be very difficult to make up for the damage she’s done in just a few days.