The Truss government’s supply side political economy has collided with the realities of the contemporary economy, says Ismail Erturk.
The recent ‘mini’ UK Budget that was overtly presented as a supply-side recipe for economic growth - with tax cuts for high-income earners and businesses and the uncapping of bankers’ bonuses - has attracted criticism from a wide spectrum of political and economic convictions.
In particular at a time when social emergencies, the cost-of-living crisis, and worsening inequality dominates economic policy agendas globally, prioritising the upper end of the wealth pyramid to spur economic growth – so called ‘trickle-down economics’ - did not go down well.
The Budget also attracted criticism not only for its supply-side single-mindedness but also for its lack of coordination with key public sector institutions such as the Bank of England and the Office for Budget Responsibility.
Recipe for economic growth
Speaking in the aftermath of the Budget both the International Monetary Fund (IMF) and eminent business leader Sir Stuart Rose were among those who said that economic growth required policies that reduced income and wealth inequality, and addressed the cost-of-living crisis.
Indeed, for quite some time the IMF’s recipe for economic growth has been policies that reduce inequality and produce high-wage jobs, one the previous Tory government of Boris Johnson also agreed with, as evidenced by the levelling-up agenda.
Businesses too have acknowledged the social emergencies by openly discussing the need for a stakeholder capitalism and implementing environmental, social and governance (ESG) initiatives.
Consequently, we have witnessed a dangerous collision of the government’s supply-side political economy with financial stability. Only the Bank of England’s heavy intervention in bond markets prevented a potential financial crisis.
Unfunded tax cuts, the core of the Truss government’s supply-side economic policies, together with the financial support for energy costs of low-income households, increases the government debt without any realistic future improvement in sight. The government has failed to convince the financial markets that the supply-side economic measures would ultimately generate prosperity for all and reduce the budget deficit.
In our complex financialised economy the nodes of myriad financial institutions and markets are linked, mostly in a fragile way, through untested financial innovation.
This time, a financial innovation known as ‘liability driven investments’ in the pension fund industry - a process that is supposed to hedge long-term financial liabilities of pension funds through synthetic solutions in financial derivatives markets - failed when gilt prices declined sharply following the government’s unfunded tax cuts, threatening the solvency of many pension funds in the UK.
The sharp fall in gilt prices then reduced the value of collaterals used by pension funds in hedging their investment risks, starting a ‘doom loop’ where pension funds had to liquidate their UK government bonds to meet their margin call requirements.
The UK government bond prices, consequently, went even further down putting the solvency of pension funds and overall financial stability at risk.
According to the government’s economic thinking the immediate distributional benefits of tax cuts for the higher income earners and businesses would in the longer term generate jobs and growth.
However, the financial market’s response to the government’s supply-side political economy was a disapproval of this view. The pound’s value plummeted and the government’s credit risk jumped up at unprecedented rates in a matter of days, thereby creating the conditions of a major financial crisis emanating from the pension fund industry.
Businesses also responded by reminding the government that tax cuts alone do not stimulate investment under the conditions of high inflation, a cost-of- living crisis, and high interest rates, all of which erode the purchasing power of consumers and hence the possibility of economic growth.
Also, it is worth remembering that businesses invest not just because tax rates are low. They invest primarily if they see demand for their products from consumers with purchasing power.
Most businesses have high levels of debt too. So a reduction in tax is more likely to be used to deleverage and increase cash reserves rather than investing for growth. In the US, for example, the Trump administration’s tax reduction did not lead to new meaningful investments by US businesses.
Additionally, the present-day economy suffers from post-Covid disruptions to supply chains and labour markets where production capacities are not being reached in many sectors. This hurts company profitability and use of existing capacity.
As such the government’s supply side political economy has collided with two realities of the contemporary economy. Firstly, the fragility of financial markets that are disconnected from the real economy. And secondly, the societal emergencies that have been building up since the 2008 financial crisis and that are associated with low economic growth.
Even the IMF, the most business and market friendly of all international institutions, now recognises that we are in an economic landscape dominated by financial instability and societal emergencies. As such, fiscal policy that ignores these realities tends to disappoint like the UK case has shown. Indeed, any government that ignores the forces of financial stability and societal emergencies does so at its peril.
It is therefore not a surprise that the Truss government has now reversed the plan to scrap the top rate of income tax and also allowed the Bank of England to exercise its independence in dealing with financial stability risks.