Here endeth the lesson

The "unholy alliance" that sank Truss and woke Scholz

The EU should give thanks to the UK. For a live educational experiment in the limits to national sovereignty and the costs of institutional enfeeblement, the 2019-22 Vote Leave government will be hard to beat.

The absurdly high hopes VL raised meant its governments were always going to fail but even Remain Cassandras should marvel at the speed and scale of the collapse of the project fronted by Boris Johnson and Liz Truss.

The project’s chaotic phase during Theresa May’s transitional Conservative administration and the first VL term under Johnson were understandable; even the revolutionaries among them didn’t know what they wanted. To her credit, Truss and her campaign forced Brexiteers to pick a side: Danton or Robespierre.

It turns out that Dominic Cummings, Rishi Sunak, and Michael Gove just wanted national liberation combined with a return to the fiscal orthodoxies and economic and social liberalism of the John Major and Tony Blair governments. Truss and her short-lived Treasury team, on the other hand, birthed an anglo-Reaganite current that sucked in the likes of David Frost and Nigel Farage. With massive unfunded tax cuts, the Trussistas would starve the state, forcing previously unthinkable public-spending reductions together with growth-enhancing reforms.   

Too young to read

There were a few problems with this starvation strategy. Chief among these was political reality, which Truss and her mayfly economic team – Kwasi Kwarteng and Chris Philp – might have anticipated had they been reading age when David Stockman quit Ronald Reagan’s administration in 1985. A self-confessed political naïf despite being a three-term congressman, Stockman became Reagan’s first budget director in 1981 and discovered to his shock that politicians like cutting taxes a lot more than cutting spending - an experience he recounted in his 1985 book The Triumph of Politics. As a result, Reagan’s huge first-term tax cut – the equivalent of 3% of national output – had to be reversed within a decade.

The second related problem was the vacuum where Truss’s “radical supply-side reforms” were supposed to be. This is hardly surprising since these included election winners like graduating public-sector pay according to the regional cost of living, fast-tracking planning permission for infrastructure projects and for approving housing estates in green areas of Tory constituencies, and phasing in an insurance system for healthcare.

The third and most obvious tripwire was the trade-off between fiscal and monetary policy. In fact, Truss and her gurus – Patrick Minford, Gerard Lyons and Julian Jessop – were politically innocent enough to say this out loud. If the government takes action to stimulate growth by widening the budget deficit, the Bank of England should compensate for any increase in inflation pressures by raising interest rates. That’s the theory, anyway. In political practice, 1.8 million households took out two-year fixed-rate mortgages at historically low rates in 2020 when Sunak cut stamp duty. They will have to refinance next year at much higher rates.

The results from the anglo-Reaganite experiment are in:

Source: Politico poll of polls

Surveying the wreckage, foreigners are baffled at how one of the world’s most developed democracies and most open economies fell so low so quickly. Easy. An electoral system built to sustain two coalitions disguised as parties that elect their leaders by a membership vote is vulnerable to hijacking by extremists. Gove is famous for saying “the people of this country have had enough of experts with organisations with acronyms saying that they know what is best and getting it consistently wrong” but it was the Brexit process itself that chipped away at rules-based policy and institutional guardrails.

Like any group with heterodox ideas, this one found an echo chamber with its own “experts” to reinforce the heterodoxy. Cheered on by commentators like Matthew Lynn, Allister Heath, Liam Halligan and Andrew Lilico, and reassured by two City economists (Lyons and Jessop) and hedge-fund managers Crispin Odey and Andrew Law, Truss and Kwarteng had all the expertise they needed.

By the time the chancellor unveiled his “mini-budget” on 23 September, he’d removed the Treasury’s permanent secretary and dispensed with scoring from the Office for Budget Responsibility (OBR). There’s nothing magic about the OBR. Jacob Rees-Mogg wasn’t wrong to say “the OBR is not the only organisation that is able to give forecasts" but, if his government had conducted a survey of public- and private-sector forecasts, the result would have been the same. And it wouldn’t have been Lyons’s and Jessop’s sunlit uplands. Within two weeks, credit-rating agencies S&P Global and Fitch had revised their risk assessment for a debt default from stable to negative.

Even before Truss reversed her core tax initiative and handed unlimited power to Jeremy Hunt, the three-week-long anglo-Reaganite experiment was over – sunk, in Matthew Lynn’s words, by an “unholy coalition of the bond markets, the civil service, much of the media, and most of all Conservative MPs”.

The rules that bind

Farcical as this episode has been, there is nothing uniquely British about it. Without rules and institutional guardrails, policy discipline has to be outsourced to the bond markets. Few politicians lack self-belief, few choose experts who disagree with them, and all crave full policy-making discretion. Nicolas Sarkozy, the former French president, came to power driven by a commitment to volontarisme and the motto “if you want to, you can”. His predecessors’ passivity and fatalism, he believed, had fed popular cynicism and extreme politics.

Sarkozy was cursed by governing a decade too early. Even before the pandemic struck in 2020, the European Commission and the European Central Bank were encouraging more expansive fiscal policies. In 2018, they resisted the budgetary rebellion by the M5S-Lega government in Rome but still reached a settlement well outside their fiscal rules.

Since 2020 and the suspension of these rules, the only fiscal constraints on governments come from the bond markets and the perceived willingness of the ECB to buy public-sector securities in an emergency. During the pandemic and with the ECB as the guaranteed buyer of their bonds, governments were given almost free rein to increase borrowing to cushion the impact of the coronavirus. Although support programmes were meant to include sunset clauses, many spending items have leaked into governments’ 2022-23 accounts.

Now comes the energy-price shock and intensifying pressures on governments to inject at least 5% of GDP (more than €600 billion) into the economy. One government in particular – the one going through a painful formation process in Rome – is arguing over a Lega proposal to extend its “flat tax” regime to the higher-earning self-employed. Echoing Truss’s echo chamber, Lega leader Matteo Salvini claims it will “pay for itself”. It really won’t.

For months, the German government has refused to face up to the risks that a budgetary free-for-all would pose this winter. The political pressure on the new Italian government will be intense but, without the market credibility of its predecessor under Mario Draghi, bond yields could soar. This would then place an unbearable burden on the ECB – a burden that, like the Bank of England, it would provide for only a limited period. Having watched the speed of the unravelling of the Truss project, German chancellor Olaf Scholz has declared himself open to another joint EU programme to finance government inflation-mitigation measures through 2023.