BY JAMES FAULKNER
This is the first Tory government since Thatcher – but is it too late?
The “KamiKwasi” budget is how an apoplectic media establishment is framing Chancellor of the Exchequer Kwasi Kwarteng’s so-called “fiscal event”. Prime Minister Liz Truss’s new finance minister aimed to shock and awe the markets – and he certainly did. Sterling tumbled to an all-time low against the almighty US dollar; UK government borrowing costs soared; and the Bank of England was compelled to make a statement to reassure the markets that it would act forcefully where necessary to stabilise the pound. Sir Keir Starmer’s Labour Party – up until recently a political non-entity – can smell blood as they crow, with more than a hint of schadenfreude, that the government is “out of control”. Reminiscent of the “wets” of Margaret Thatcher’s government, some cold-footed Tory MPs are said to already be handing in their letters of no confidence to the 1922 Committee.
A bleak picture indeed. At least on the face of it. Yet there is an air of confidence about this new administration that belies the apparent chaos that they have unleashed on the country’s finances. This government has torn up the past 12 years of Conservative economic management, in favour of a radical growth agenda that threatens to smash apart the “One Nation” coalition of right and left within the Tory Party. Gone are Blairesque tropes like “Compassionate Conservatism” and the “Levelling Up” agenda, to be replaced by sweeping tax cuts, supply-side reforms and an unashamedly pro-enterprise and pro-aspiration agenda. These are bold moves that have required the government to once again resort to the nation’s credit card to foot the bill. The party that once denied the existence of a “magic money tree” now seems to have discovered an entire forest.
Yes, this government stands a good chance of destroying what remains of the Conservative Party’s reputation for economic credibility and putting Labour back in power for a generation. But at this stage, attempting to maintain the status quo could very well deliver the same outcome. In fact, KamiKwasi’s ‘divine wind’ could be exactly what the country needs and might have arrived just in the nick of time. The legacy media would have us believe that Kwarteng is an economic illiterate, splurging the cash in a witless effort to pander to the rich while the rest of the country goes up in smoke. But with a PhD in Financial History, Kwarteng could be the first chancellor in a generation that really understands money.
Hailing from the financial sector myself, I can tell you that the world is in the midst of a major paradigm shift. Since the financial crisis of 2007-09, we have been fed the opium of cheap credit in order to ameliorate the worst symptoms of recession. But like any drug addict, we’ve found it difficult to ween ourselves off and even relapsed completely during the Covid lockdowns. We went cold turkey when the war in Ukraine and the supply-chain upheaval caused by the reopening of the world economy sent inflation skyrocketing and forced central banks to raise interest rates aggressively. The era of cheap money has come to an end. This has profound consequences for markets and for economies. Kwarteng knows this and he wants to get ahead of the curve.
Up until recently, interest rates across the developed world had been at 300-year lows for around a decade. It is hard to exaggerate the distorting effect this has had on markets. It has incentivised consumption and penalised saving, whilst at the same time attracting capital into sub-par investments and businesses. The last point is crucial, because there are now many businesses – not just in the UK but across the world – that would be uneconomic at ‘normal’ levels of interest rates (historically speaking, around 5% in the UK). If the cost of money is artificially low, the ‘hurdle rate’ for making economic decisions is also low, meaning that low interest rates have led to the proliferation of low-return investments and businesses as capital has sought out any kind of return possible in order to beat low rates. It is this misallocation of capital that is likely a major factor behind the sluggish growth experienced in many major economies since the financial crisis.
Setting aside the energy support package, which is intended to stabilise households and businesses in the face of soaring energy costs, Kwarteng’s borrowing splurge is not primarily intended to support demand. Instead, Kwarteng is targeting the supply-side of the economy, as this will ultimately provide the cure for high inflation and the cost-of-living crisis, through unleashing the productive potential of the economy.
The chancellor received major criticism for abolishing the 45p rate of tax for the highest earners. Clearly, the optics of this move are not great in a cost-of-living crisis, making it an easy target for Labour. But real Conservatives know that the more you tax something, the less you get of it. By abolishing the 45p tax rate, Kwarteng wants to encourage more high-value economic activity at the margins, thus increasing the supply side of the equation. As an added bonus, incentivising higher earners to earn more through lower taxes can actually increase tax revenues (Google “Laffer curve”), as it did when the Thatcher government successively cut the higher rate of income tax all the way down to 40% – where it stayed until 2010. Letting higher earners keep more of what they earn also bolsters the entrepreneurial classes, who will be crucial to facilitating this transition.
In the meantime, higher borrowing will force the Bank of England’s hand to raise interest rates more aggressively than they had previously envisaged. This spells major pain ahead for many businesses and families, but it also means that the shift to a new equilibrium will be quicker and less drawn out. The government’s borrowing costs will rise, but high inflation will help keep borrowing at bay as a percentage of GDP, at least in the short term. Higher rates will raise the bar when it comes to making economic decisions and assessing the prospective return of a business investment, which in turn will concentrate activity in higher growth areas and improve GDP growth rates in the long run. Major reforms of planning laws, the introduction of new ‘enterprise zones’ and – in true Thatcherite tradition – a confrontation with troublesome unions are all on the cards, along with a major overhaul of EU-inspired red-tape.
Make no mistake, this new government marks a major break with the past. Aside from a bit of tinkering here and there, the last three Prime Ministers were content to assimilate the Blairite tradition of managed decline. Years of so-called austerity have left us with a bloated state and taxation at its highest level since the 1950s as a share of GDP. This government has a radical approach to confronting and adapting to the economic challenges we now face. The transition will be painful. The major question is whether the government’s policies can begin to make an impact in advance of the next election in 2024. By then, we’ll know which way KamiKwasi’s divine wind is blowing.
James Faulkner is Digital Content Manager at Sarnia Asset Management (SAM), a Guernsey-based fund management company. Having started investing in his teenage years, James began his career in the City as a market commentator and researcher. He edited several investment publications including Small Cap Shares, T1ps.com, and Master Investor before joining SAM in 2021. James holds the IMC designation and is a member of the CFA Society of the UK.