EXPERT COMMENT After Liz Truss

By Professor Ignazio Cabras and Dr Emilio Carnevali 

In April 1985, just days after being elected general secretary of the Soviet Communist Party, Mikhail Gorbachev visited a district on the outskirts of Moscow. The road leading to the local hospital was still hot and steaming with fresh tarmac laid just hours before his passage. Patients in the hospital were impersonated by zealous security officers, perfectly shaven and well-fed. They cheerfully praised food and medical staff but struggled to describe exactly what illness they had. After that visit, the first thing Gorbachev did was to improve access to reliable information: an extremely difficult task even for the supreme leader of the then USSR.

During the 44 days Liz Truss was PM, Downing Street resembled the hospital Gorbachev visited: a fictitious construction trying to cover up the inconvenient truths coming from the outside world. Truss promoted the construction of papier-mâché walls, surrounding herself with yes-men and repeatedly denying evidence on the British economic situation provided by publicly accessible data.

Useful lessons must be learned from the last government. To do so, it is essential to understand exactly what happened. From different readings of the facts, we can draw different indications of the economic policy constraints with which future British governments will have to contend. Rishi Sunak will face an "emergency" economic policy which will also deeply affect the government emerging from the next general election. 

Janan Ganesh wrote in the Financial Times that what has been wiped out by the disastrous experience of the Truss government are the "libertarian" utopia of the right-wing Tories as well as the "progressive dream" of the British left. From now on, there will be no alternative to austerity, recklessly dismissed as "abacus economics" by Liz Truss. Abacus economics would be nothing more than the rational realization that we, as a country, cannot live above our means. Still perhaps we can interpret facts by avoiding simplistic ideological juxtapositions and focusing on data so adamantly ignored during her infamous 44 days.

When Liz Truss became PM in September 2022, the unemployment rate was at 3.5 percent - the lowest rate since 1974; and inflation at 10.1 percent - the highest level since 1982. Inflation was also believed to still be far from the expected peak in early 2023. Last summer, reports from Bank of America and Citigroup estimated inflation between 15 percent and 18 percent by January 2023. Against this backdrop, the Truss government approved a £45 billion deficit tax cut plan, a substantial portion benefiting the wealthiest, aside a two-year plan of generalized subsidies to household and business energy consumption. The costs of the latter package were difficult to predict, but the government estimated them to be around £60 billion for the first six months. This move would have forced the Bank of England towards an even more aggressive interest rate tightening to keep inflation in check and curb the pound depreciation.  Once the markets incorporated these expectations into asset valuations, the perfect financial storm was unleashed, tearing down the paper-thin walls of Downing Street's fairy-tale court. At the end of August, the interest rate on 10-year British government bonds was below 2 percent. By the end of September, it jumped above 4.5 percent. The collapse in the value of these assets triggered margin calls on derivative contracts signed by British pension funds that had government bonds as collateral, initiating a perverse mechanism that jeopardized UK financial stability, with banks halting the disbursement of new housing mortgages in the impossibility of making reliable forecasts of future rate trends.

However, markets were not afraid about the UK failing to honour the promised tax cuts. The solvency of a state that issues government debt securities denominated in its own currency cannot so easily be questioned. This was demonstrated by the decision of the Bank of England to buy long-dated securities on September 28th. An exceptional intervention, yes. But not unprecedented. In April 2020, as soon as the Covid 19 pandemic broke out, the Bank of England unleashed the "Ways and Means Facility", a sort of unlimited overdraft through granted to the government on monetary reserves backed by no new government bonds. Even then, the government spent without worrying about later bills, and rates on government bonds fell as markets expected an accommodating monetary policy from the Bank of England.

At the height of the recent crisis, many observers raised the alarm when yields on British five-year bonds exceeded those on Italian bonds of equivalent maturity. Anyone monitoring the performance of credit default swaps (the insurance cost against the risk of sovereign default) would have noticed that those in the UK remained well below those in Italy, a country that manages its public debt within entirely different institutional settings. 

In short, the markets did not fear the British Treasury running out of money but a disastrous economic policy that would have sent inflation out of control and exacerbate the current account deficit situation (now at 5.5 percent of GDP). A further weakened pound and soaring interest rates would have meant public and private investment plummeting, with a devastating impact on long-term growth prospects.

With Liz Truss gone we have freed ourselves from the amateurish dogmatism of those who thought they could comfortably bend reality to their ideology.  We now must hope that the dogmatism of balanced budgets “whatever it takes" does not replace intelligent and shrewd economic policy informed by reliable data, effective analysis, and well-balanced objectives.

As for the progressive dream gone with the Truss government, Labour has no reason to despair. Rarely in recent history there was such an auspicious alignment between economic reasoning in favour of higher taxation of wealthier segments of taxpayers, and social justice pushing for a greater redistribution of income and wealth. If Labour can focus on reasons rather than dreams, it may have a truly historic opportunity at hand.