September 2022: the market bites back

Every media outlet is currently asking the same question with regard to this period of, for want of a better phrase, financial uncertainty – what the hell is going on?

Some blame it directly on the mini-budget last week (if one can call something that hasn’t been costed a budget at all: however, I’ll use that term here for convenience); others see that is merely being the final straw in a series of misjudgements that stretch back decades. For some, the judgement of the new administration is immediately shown to be suspect; others claim that this is the only long-term solution to the problems we face. Some see this as proof that capitalism is inherently flawed; others argue that only the free market can come to the rescue of our economic woes. For many, including me, it’s all slightly like watching a massive car crash, the causes of which are as unclear as is the scale of the final casualty list.

Each person’s reaction is also coloured by how this affects them personally. Most changes produce winners and losers, though they are rarely the same number of each. All of us are looking for ways to mitigate any disadvantages and maximise any benefits. That is, after all, what an economy is – millions of different people doing a million different things, each hoping that just the right blend of individual reward and collective benefit can be found to keep life going on in a roughly upward trajectory. This term increasingly, and pleasingly, now incorporates not just wealth but also other considerations like happiness, health and environmental responsibility. However, these need (once again) to step into the background: for what we are talking about here is money.

Having read a few articles, listened to a few radio programmes, talked to a few people and drunk quite a few cups of strong coffee, it seems to me that the reactions to what has happened, and why, can largely be put into two piles. (Knowing very little about the subject may have helped – you might disagree – as I was able to approach it without too many preconceptions.)

Two explanations

Explanation number one is that the turmoil in the financial markets following the mini-budget last week is a direct result of the market being taken by surprise. Something in the Chancellor’s speech must have spooked it. Many of the measures had been mentioned during the protracted election campaign but others, like the two income tax cuts, had not been. The combination of falling revenues and increased spending (including on subsidising energy prices) plus a paucity of detail led the market  taking a negative view of the plans and, in turn, to an increase government’s borrowing costs.

The knock-on effect of this has destabilised pension funds and led to the Bank of England needing to step in by increasing interest rates and buying up gilts at a cost of at least £65bn. However, the government believes that all this volatility will calm down as markets dislike febrile change as much as they dislike uncertainty.

Explanation number two is that the new administration has sacrificed financial prudence for ideology. Despite so many of the problems we face requiring a big-state approach, the government has adopted a small-state funding model. The proposals represent an over-risky gamble to pull the the country out of recession by relying on tax adjustments, plus the trickle-down effect, to put more money in people’s pockets. No less a body than the IMF warned against this and suggested that the proposals should be re-visited.

The PM and the Chancellor have experience in business and finance and should have anticipated the market’s reaction. The particular solutions adopted were also inequitable. All this comes at a time when there is also a looming cost-of-living crisis fuelled by a number of mainly external factors. This was not the time to indulge in experiments based on points of principle.

Picking the problem

The truth of the matter – if truth exists actually in economics – is probably about a thousand times more complex than either of these. A useful starting point in judging the government’s actions is knowing what particular problem it was trying to solve.

There are at least four massive challenges at present: recession; inflation; financial inequality; and the cost-of-living crisis. I doubt that any one measure can effectively deal with more than one at a time. The government’s plan appears to be to concentrate on the first. It further appears to have decided that a healthy financial-services sector and profitable business are essential prerequisites. Get those right and everything else will follow. If one accepts that, the mini-budget makes a bit more sense, though opinion is clearly divided as to whether the right measures have been taken and whether they should have been taken now.

Taxes, taxes everywhere

Liz Truss has made no secret of her desire to cut taxes. This doesn’t have to be ruinous to government revenues in the medium term. Sometimes when a tax band is cut then the revenues from it can rise as more individuals and companies will be incentivised to work and also – and this aspect should not be ignored – disincentivised from using tax-avoidance schemes.

Taxes bite everywhere, of course, and not just in our pay packet. If you spent £100 on petrol, £100 on wine and £100 on a VAT-registered tradesperson’s bill, about £90 of that £300 would be going straight to the Treasury. This is all coming out of taxed income, of course. Reducing the tax burden stimulates the economy although, as the 1980s showed, often has to be paid for with cuts to services. The trick for a government is ensuring that these cuts are neither politically disastrous nor likely to cause even more expensive problems further down the line while at the same time enabling the government to afford to borrow enough to make up the shortfall. Liz Truss appears to be betting the house on the fact that the benefits will be felt before the bills start coming in.

One immediate problem is that the combination of inflation and interest-rate rises (the method generally used to deal with rising prices) is likely to wipe out any benefits that tax cuts produce. Anyone not on a fixed-term mortgage is likely to see this cost rise by more than can be offset by any increase in their pay packets. Given that so many of us have mortgages and that home ownership has been a cornerstone of Conservative Party orthodoxy since 1979, some help might need to be provided for that if the housing market isn’t going to collapse.

This might therefore be the time to re-introduce MIRAS (mortgage interest tax relief) which was in place from 1983 to 2000. This will, of course, only further increase the deficit between government income and expenditure. It would also add yet another group to the list of those receiving government support of some kind or another. This is contrary to what our ruling party believes should happen. The fact that so many such support measures are needed, and that more are likely to be, perhaps suggests that salvation through tax cuts is not going to be enough.

The cut in corporation tax will affect every business that makes a profit. However, what really counts is whet the business owners do with the extra dosh. Not all will follow the lead of one local business owner I spoke to recently who, as soon as the corporation tax cut was announced, gave all their staff a pay rise. Other less edifying options exist, including taking all the extra money out in dividends and filching it away offshore. It could also be that this has an inflationary effect as suppliers will put up material prices knowing that the companies will be better able to afford them.

A missed opportunity?

One tax cut that would have been deflationary and also vastly more equitable than any of the measures proposed was a cut in VAT. Everyone pays this several times a day, often without knowing it. In that sense, it is a brilliant tax. (Even more brilliant is that it has given the state millions of unpaid tax collectors in the form of every VAT-registered person or company.)

Perhaps this was rejected because it would have caused businesses problems with accounting and re-pricing: also, perhaps, that the savings would not have been passed on to consumers (though, if so, this would have boosted business profits, seemingly the main object of this mini-budget). No fiscal or any other measure is free of such applications of the law of unintended consequences.

Plans and communication

There’s also the question of how long any of these measures will take to work through to people. Some of the tax cuts won’t happen til next year and many of the people most in need don’t pay tax at all. Nor will any outpouring of entrepreneurialism and hard work that the measures seem designed to encourage be seen quickly. The government could, of course, re-position these as part of a medium- or long-term plan, the inference often being that the longer time a project takes to reach its fulfilment the more solid and worthwhile its results will be. The reality is that a medium-term plan is all too often little more than a short-term plan that’s gone wrong.

A delay of a different kind has also perhaps been the main reason why the markets reacted so badly. The mini-budget did not come with the kind of supporting evidence and official accreditation that is normally expected. These details are promised on 23 November, an aeon of time for the financial world to wait. The market may make hard-nosed decisions but it’s not entirely free of sentiment. It it feels that something has been withheld from it or sprung on it or perhaps just doesn’t “feel right”, it’s capable of having a hissy fit.

I’ve suggested in the past that most things that go wrong do so not due to malice or a deep-seated conspiracy but rather because of incompetence or poor communication. The latter is particularly in evidence here: as for whether the former had any role to play, time will tell.

The shock of the new

The big challenge for most people is not so much that things like interest or inflation rates change; what does knock us sideways is when they do so suddenly. As with the mini-budget, one can be given plentiful warning about this but we only really believe it when it actually happens.

We have recently become addicted to both these rates being very low. Inflation has been at less than 10% since 1982, less than 5% since 1992 and less than 3% since 2012. Interest rates have been less than 10% since 1992 and less than 1% since 2009. In 1979, by contrast, they were at 18% and 17% respectively. A decade or more of flat-lining is now over.

The steep and partly unexpected rises have spooked us, just as the financial establishments were spooked by the unexpected content and extent of the Chancellor’s announcement. A new set of realities are looming up ahead but it’s currently impossible to make out more than their vague outlines. No one, individual or corporate, likes this very much. Perhaps, after all, the market is a more accurate reflection of human nature than we find it comfortable to admit.

Brian Quinn


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