Why did Truss's planned removal of a tax increase cause the market/pound to tank?

Question

I'm having a bit of trouble wrapping my head around this one. Why was it that when a tax break (or, removal of a tax increase) was announced, the market and pound reacted negatively? Wouldn't the market prefer lower cost of doing business?

Answer 1

The problem with the mini-budget was that it included large tax cuts, but with no corresponding cuts in spending, or increases in other forms of revenue. This implied that government borrowing would have to substantially increase. None of that appeared to have been planned nor discussed with anyone else, including the Office for Budget Responsibility.

The "markets" here aren't the individuals or companies who stood to gain the most. It's the financial markets who buy and sell currencies, shares and commodities.

Sudden unplanned borrowing by a government results in rising interest rates, which further increases the cost of that borrowing. The markets consider such an economy to be a high risk.

Answer 2

There is yet another problem wrt government debt/bonds: inflation.

Basically, while the overall situation has been addressed on other answers in terms of debt and viability expectations, one also needs to remember that the UK, like many other countries, is facing extremely high inflation.

Truss's tax cuts were seen by some as inflationary (injecting more money into an inflationary economy).

Thus it was also widely expected the Bank of England would move in the opposite direction and increase interest rates.

(Sept 22) Liz Truss’s selective Reaganomics won’t work | The Economist

Liz Truss, Britain’s new prime minister, is now implementing Reaganomics in Britain, again creating dissonance in economic policy. The Bank of England (boe) is fighting annual inflation of 9.9%. On September 22nd the bank raised interest rates by 0.5 percentage points. Yet the next day Ms Truss’s government was scheduled to lay out details of an enormous fiscal stimulus, comprising tax cuts worth perhaps £30bn ($34bn) per year (1.2% of gdp) and subsidies for energy bills whose total cost across two years could reach £150bn.

The fuel that fiscal stimulus will inject into the economy will almost certainly lead the boe to raise interest rates faster than it otherwise would (despite the fact that price caps on energy will bring down measured inflation).

One thing to remember there is that bonds are less attractive as interest rates go up and that affects their prices and rates. Which gets people to ask more to finance debt via bonds and lowers the prices of existing bonds. See also Investopedia: How Are Bond Yields Affected by Monetary Policy? .

i.e. "These bonds are gonna stink down the line, so I am less interested in holding them (lower price) or you have to pay me more (higher rates)!"

It probably didn't help that Truss had also been musing about bringing central bankers under more control. And, well, inflation is a problem and Truss was going to make it worse.

Answer 3

This is a very good question, although perhaps not quite for the reason that you think. To be clear, what we want to be able to explain is why the Truss-Kwarteng fiscal event resulted in both,

1. A fall in the price of the Pound, relative to other currencies.

and

2. A decrease in the market price (i.e. increase in yield) of UK government bonds (gilts).

Let's first consider the fiscal policy announcements made by the British government on September 23rd. You can see a detailed breakdown here, but the two main points were:

• Approximately £60bn of subsidies for household and business energy bills over the next 6 months.
• Tax cuts costing about £45bn through to the end of the 2023 financial year. This is mostly made up of reduction in taxes on income and corporate profits.

The energy subsidies had already been announced, so are unlikely to have been a factor in the market reaction, but the tax cuts were new (although some had been promised by Truss during her party leadership campaign) and so it is reasonable to infer that they motivated the markets' behaviour.

Orthodox economics says that tax cuts will increase the aggregate demand in the economy. This in turn will result in demand-pull inflationary pressure. As the UK has an independent central bank, with a primary mandate to manage inflation, this inflationary pressure is likely to cause a rise in the official bank rate and a corresponding rise in the interest rate of other financial instruments, such as gilts. Since the coupon on existing gilts is (in most cases) fixed, the market price of those gilts will fall, bringing their yield back in line with the new, higher, interest rates. We can therefore understand the second of the two market reactions described above. What about the fall in the Pound?

In this case, conventional wisdom isn't so helpful. The traditional expectation is that an increase in interest rates in a country will cause the price of that country's currency to increase, since financial instruments denominated in that currency become more attractive to investors. However, here the opposite happened. This is quite unusual, but not unique. As Paul Krugman points out, this is the sort of behavior that one might expect to see exhibited by a developing, rather than advanced, economy. The argument put forward by Krugman, and many others, is that the attractiveness of the Pound due to anticipated interest rate rises has been more than offset by market fear over the UK government's lack of fiscal credibility. This has been described as the "moron risk premium".

In summary, the currency and gilt market movements can be understood as having two components:

1. Response to anticipated increase in short term UK interest rates, which causes the Pound to appreciate and gilts to depreciate.

2. Lack of confidence in the British government, which investors perceive as their shouldering increased risk and so causes the Pound to depreciate and gilts to depreciate.

If the magnitude of the second effect is greater than the first, then the observed market movements can be understood.

You might, not unreasonably, object that we still haven't really understood the market movements. What exactly is this risk premium or, to put it another way, what future event are markets concerned about? Simon Wren-Lewis has written an interesting piece on this here (the most relevant part is the appendix). His argument is that the big problem with the Truss-Kwarteng fiscal event was that it included unfunded tax cuts. An important point here is that unfunded doesn't just mean unmatched by spending cuts, governments can and do fund new expenditure with borrowing, but on this occasion the government simply didn't say how it was going to pay for the tax cuts at all. Indeed, it even prevented the Office for Budget responsibility from offering their assessment of the proposals, which probably exacerbated the issues even further. As Wren-Lewis explains, the presence of an unfunded commitment in the proposals meant that markets were left guessing how the treasury was going to make up the shortfall. Given the (then) chancellor's track record, a reasonable guess was that this was going to be achieved with spending cuts, which would themselves have decreased aggregate demand. In fact, given the nature of the tax cuts, and the likely spending cuts, it is quite plausible that the net effect would have been to decrease aggregate demand, which would also have resulted in lower interest rates. Markets were therefore faced with a wide range of possible medium term UK interest rates. This is what is meant by a "risk premium". Faced with this uncertainty, market participants naturally chose to reduce their exposure to assets denominated in Pounds, especially gilts, leading to a deprecation in both gilts and the price of the Pound.

As an epilogue, note that while the price of the Pound has largely recovered from its fall following the fiscal event, the same is not true of gilts and the British government, as well as British borrowers more generally, are still faced with higher borrowing costs.

Answer 4

Tax cuts aren't always positive. Sometimes they are, sometimes they aren't. It always depends on the circumstances. In this case, the markets must have thought that the effective result is more negative than positive and gave corresponding feedback. Why could that have been?

A tax cut has always two implications. Some people have more money left but the government can also afford less or must borrow more. More borrowing increases borrowing costs but the additional factor here is the outlook of the economical development. Is a tax cut accompanied by tightened finances more likely to lead to growth (also in the long term) or less? If you believe that every functional government needs at least some funds, then there clearly exist an optimal tax rate with tax cuts beyond being poison for the economy. Many people even believe that during times of crisis like this one, governments should spend more not less, which would require adequate funding.

Markets might have gotten doubt about the long term ability to fulfill all its obligations including debt services of the British government. And indeed the debt to GDP ratio of Britain is relatively high.

But I wouldn't exclude that it was just financial speculation. After all a higher bond rate of UK government bonds is great for bond holders. They might just have seized the opportunity. After all, another PM, Margaret Thatcher, very successfully cut taxes in the past (albeit under quite different circumstances). Therefore it's not clear why the market reaction this time had to be that strong and that lasting (after all the plans have been reversed, but the bond rate hasn't gone down that much again).

Answer 5

Tax cuts for people who have the money to invest in companies and employ people tend to be a net plus for the economy. Removing those tax cuts harms those peoples' power to employ people and invest in general, which harms the economy (increased unemployment, reduced productivity, reduced innovation, etc. etc.) and ultimately hurts the government by reducing tax income as well. All of that ends up harming the currency, obviously.