Not even Margaret Thatcher oversaw a package of tax cuts and deregulation as bold as the one just announced by Britain’s conservative government. The first major government initiative under Liz Truss, the new prime minister, it is estimated to cut individual and corporate income taxes by more than 45 billion pounds a year, according to Britain’s Institute for Fiscal Studies. That would make it the biggest tax cut Britons have enjoyed since 1972 — three years before Truss was born.
Tax cuts aren’t the only thing on the agenda; there is a massive subsidy already planned for household energy prices that will offset the war in Ukraine’s disruptions, and Kwasi Kwarteng, chancellor of the exchequer, promised on Friday to reform child care, immigration, agricultural productivity, business regulations, digital infrastructure and barriers to homebuilding. But the tax cuts and subsidies loom largest in the near term — and markets aren’t happy about it.
Shortly after the government’s announcement, yields on British government bonds shot up, while the value of the pound dropped sharply on currency markets. That’s an unusual combination in rich world financial markets, but it makes sense when you consider that British inflation is currently running at 8.6 percent annualized.
Some of the market reaction might be due to market worry about the government’s fiscal position: The more money you borrow, the harder it is to pay it back and the higher your likelihood of default. But it still isn’t all that likely that Britain will pull an Argentina and tell its bondholders to go pound sand. The greater risk is that by pumping more money into the economy, the government will fuel further inflation.
That inflation will erode the buying power of the British pound (which is why the pound fell) and eat away at the face value of government bonds (which is one reason why bondholders are demanding to be compensated for the risk with higher yields). Those higher yields, in turn, will increase the total amount the government needs to borrow.
The government’s defenders might retort that of course they understand this rather elementary economics, but they have other problems to worry about. Russia’s invasion of Ukraine means Britain, like the rest of Europe, faces a cold winter of brutally high energy prices. Economic growth has been sluggish — indeed, slightly negative in the most recent quarterly report. And while everyone is dealing with the dislocations of war and pandemic, Britain is also contending with the disruption of Brexit.
The country needs both government reforms and business-led investment to negotiate those adjustments and rebuild itself into an economic powerhouse capable of going it alone. It also needs to help vulnerable households through what is likely to be a grim winter. Arguably the government can’t stop to fret about transitory inflation — and even if the inflation isn’t so transitory, the government will just have to worry about that later.
But governments can’t afford to worry about inflation later; if they don’t worry, the central bank will do it for them. The Bank of England just announced its seventh straight rate hike, even as it said the economy might already be in recession.
This is something policymakers on our side of the pond are still struggling to grasp: The era of economic freebies has ended, at least for the moment.
When inflation was quiescent and real interest rates were hovering near zero, politicians could pursue their policy goals or, heck, just pander for votes, by injecting some borrowed money. And, boy, did they! But when inflation is high, the central bank will set about undoing these actions by tightening monetary policy, and markets will make you pay with higher bond yields. Boost the economy with borrowed money, and you will see the gains clawed back by higher interest rates. The resulting economic contraction and inflation will erase the political gains along with the economic ones.
Clearly, that message still hasn’t gotten through quite yet. Whether it’s Britain’s tax cuts or President Biden’s half-trillion-dollar bid to forgive student loans, governments are still spending as if there is no tomorrow, only the golden age of yesterday. And in fairness, “the free lunch is over” is a particularly hard message to hear when your economy is facing so many wrenching adjustments and you desperately need a little help. But however unpleasant the truth, it is still the truth: As long as inflation remains high, when governments spend money or cut taxes, they will need to pay for it, one way or another.
The past 15 years have convinced a lot of people that they didn’t have to face unpleasant truths, that hard realities could always be magicked away with more government money. But the real economic constraints were always there underneath, waiting to reassert themselves. Now they have, and if governments don’t deal with those realities, reality will deal harshly with them.