Liz Truss’s Short Tenure as PM Explained

Image by: The New York Times

On September 23, Britain’s newly-minted PM Liz Truss introduced a ‘mini-budget’ aimed at stimulating growth by cutting taxes on corporations and high-earners. Three weeks after it was proposed, Truss had fired her finance minister, changed her budget in a humiliating U-Turn, and, ultimately, resigned as the shortest-tenured prime minister in British history. This chaotic month in British politics was caused primarily by the manner in which financial markets reacted to Truss’s budget announcement. Shortly following the announcement, the value of the pound relative to the US dollar crashed to its lowest level ever, yields on UK government bonds rose dramatically, and inflation expectations worsened. The turmoil reached its climax when the Bank of England, Britain’s central bank, injected emergency stimulus to prevent disaster in bond markets. This saga of epic volatility in British financial markets will be studied by economic historians for decades, but how did we get here? How did a budget plan that was ostensibly crafted to jump-start growth lead to such a visceral reaction from the markets? 

Explanation #1: Inflation.

The global economy has been mired with high inflation as it attempts to crawl back from the wreckage of the pandemic. In the UK, a combination in the rise of energy and food prices has left Britons facing 10.1% inflation after September reports. In this environment, the expected response to high inflation is the enactment of contractionary fiscal policy, where the government pulls more money out of the economy than it injects into it. This can be accomplished by decreasing spending, increasing taxes, or a combination of both. Instead, the Truss budget did the opposite. The original version of the ‘mini-budget’ included a general income tax cut, a more dramatic income tax cut for those making over £150,000, and a corporate tax cut. The effect of injecting fiscal stimulus during a time of high inflation is to make the Bank of England’s job - which is to manage inflation - far more difficult. In fact, the Bank of England has raised interest rates seven consecutive times since December in order to fight inflation with contractionary monetary policy. From the perspective of the market, adding to the inflationary fire by pushing a fiscal stimulus makes it likely that the Bank of England will be forced to act even more aggressively. As the Bank of England Governor Andrew Bailey himself noted last week, “As things stand today, my best guess is that inflationary pressures will require a stronger response than we perhaps thought in August.” The express purpose of hiking interest rates is to slow the economy down by reducing the availability of credit, thereby decreasing investment. So, when investors are suddenly forced to consider higher-than-expected interest rate increases, fears of an upcoming recession only grow. This dynamic helps to explain the fearful state of financial markets in the days following the budget announcement. 

Explanation #2: The ‘Moron Risk Premium’

Some market players and economists have coined the phrase ‘moron risk premium’ (MRP) as a way of expressing how markets deal with risks related to government incompetence. If politicians and economic officials are operating in a manner that the market deems foolish, a layer of uncertainty is added to investment decisions. For example, higher returns on government bonds will be demanded and general market conditions will worsen as this so-called premium becomes priced into assets. This is precisely what happened following the actions of the British government: Truss injected fiscal stimulus at a time when the opposite was necessary, which made the markets perceive her government as irrational. These two explanations are related because the MRP would never have existed if not for Explanation #1. However, the MRP is particularly insidious because it not only puts the ‘mini-budget’ into question, but it also puts every future economic decision that the government makes into question as well. This is because markets begin to question the process by which the government makes its decisions, and if certain decisions can cause a crisis like this, the market is likely to believe that other decisions will too. Because of this, some scholars have noted that it will take years for Britain to restore its reputation for fiscal responsibility and sound economic judgment. At that point, the only remedy for the MRP was a Truss resignation and the installment of a new government. It remains to be seen whether the MRP will stay limited to Truss or if it will extend itself to the entire Conservative party.

Where do we go from here?

Since Truss’s resignation, the abandonment of the ‘mini-budget’, and the emergency stimulus from the Bank of England, market conditions have somewhat improved. Most notably, the pound has begun to rise from its historic depths and bond yields are decreasing. However, Rishi Sunak, the new Conservative PM, has inherited a party that has been thrown into disarray while Labour has seen a staggering rise in its polling numbers. In addition to addressing the problems that Truss created, Sunak faces a difficult global economic outlook, a war on the European continent, and widespread anger among the public for turning a difficult situation into a chaotic and embarrassing one. It remains to be seen whether Sunak can pick up the proverbial pieces, or if the Conservative party’s twelve-year hold on will soon come to its end.