Liz Truss must proceed ‘sotto voce’ – or lose markets’ confidence in a flash

Tomorrow will see events in London that are so momentous that they overshadow everything else in our national life. Questions of business and economics rightly fade into insignificance. Yet later in the week these matters will reassert themselves. Indeed, even in narrow financial terms this week may prove to be momentous.

On Thursday, the MPC will probably announce another significant increase in interest rates, of perhaps 0.75pc. And on Friday the new Chancellor will present what is being described as a “fiscal event”.

We are told that this will not be a full budget but, at the very least, it will formalise the rescinding of the recent increase in National Insurance contributions and the planned increase in corporation tax. Analysts and markets will be agog to see if he also announces further tax cuts and what, if any, fiscal framework he puts in place.

There are two prongs to Truss’s new economic policy. The first is a rejection of tax increases and an embrace of tax cuts funded, in the first instance anyway, by higher borrowing. The Truss team argues that there is no hurry to bring the debt ratio down and that the Treasury orthodoxy that always wants to reduce borrowing and debt is simply out of kilter with current economic and financial reality.

The second prong is a programme of radical supply-side reforms which, together with the beneficial effects of lower tax rates, is designed to increase the real rate of economic growth to 2.5pc per annum.

In general, I am a supporter of the Truss programme. Although the cost of measures announced so far is pretty large, and may be even larger after Friday, so is the hit to real incomes from the energy shock.

Actually, the reversal of Rishi Sunak’s tax rises will only cost about £30bn, not much more than about 1pc of GDP. Admittedly, the new price cap on energy costs may end up costing far more. It is plausible that the final bill will come to about £150bn over two years.

Yet this would actually be far smaller than the total cost of all support measures provided during the pandemic, which came to over £300bn.

Moreover, although the borrowing requirement would end up a fair bit higher than under Mr Sunak’s plans, it would still be considerably lower than the level it reached during the global financial crisis of 2008-10, namely about 10pc of GDP.

Nevertheless, I must confess to feeling a bit uneasy. There are two quite different threats to the Truss programme. The first is that the financial markets will lose confidence. If this happens, then gilt yields could rise considerably, thereby increasing the Government’s cost of finance, and the pound could come under substantial downward pressure, pushing inflation up and possibly prodding the MPC into sharp increases in interest rates.

Accordingly, the Truss team should proceed with considerable caution with regard to how their new approach is presented. The combination of abolishing the fiscal rules, reconsidering the remit of the Bank of England and possibly even amending the inflation target, as well as making open or veiled attacks on the Bank of England’s independence, would not be a wise way to proceed.

The confidence of the financial markets can be lost in a flash. The new team would be well advised to go sotto voce in its criticism of the Bank of England, to leave the inflation target unchanged and to retain a system of fiscal rules, albeit framed in relation to target levels of the debt ratio.

It is vitally important that the second part of the Prime Minister’s economic agenda, namely the pursuit of radical supply-side reform, has real teeth. It faces a very different constraint, namely the vocal opposition of various interest groups and even of the electorate in general.

We have already seen two recent examples of the Conservative Party abandoning radical reform proposals.

The first was the reform of the planning system which was ditched after two disastrous bye-election defeats. The second was Ms. Truss’s suggestion during her election campaign of introducing regional pay bargaining in the public sector which would see the rate of pay for the same job differing considerably in different parts of the country.

In my view, this suggestion was eminently sensible. However, it was dropped when the scale of the opposition became clear.

The two threats to the Truss programme are related. Let us imagine that, because of the innate difficulty of getting radical reforms through and intense opposition, in practice hardly any reform happens. In that case, there won’t be much prospect of achieving 2.5pc real growth, other than fleetingly.

The Truss team’s faith that substantially higher borrowing can be sustained because economic growth will reduce the debt ratio to acceptable levels reasonably quickly would be undermined. In that case, the financial markets’ confidence would fray.

Given all this, just thinking radically about economic reform is not going to cut the mustard. The Truss team will have to forget, for the time being anyway, about tackling the two huge sources of inefficiency in our economy, namely the NHS and the housing market. These will have to wait for another day.

Instead, the Truss team must focus on reform measures that can both bring tangible results and command considerable public support. I suspect that the most promising area is energy policy and the pursuit of net zero.

Of course, there is widespread and heartfelt support for pursuing the net zero agenda. But this does not necessarily translate into widespread support for particular measures or the achievement of a certain result by a particular date, especially when people can see the consequent hit to their living standards.

This is not just about economics. We are now deep in the realm of what used to be called “political economy”. To succeed with her economic agenda, Liz Truss will need to exercise political skills of the highest order.

Roger Bootle is chairman of Capital Economics. You can contact him at roger.bootle@capitaleconomics.com