New chancellor Jeremy Hunt faces a mammoth task — restoring Britain’s credibility

One down and one to go.

Talking to policymakers attending the annual meetings of the IMF and World Bank made clear the blend of amusement, anxiety and anger with which many view the UK. Kwasi Kwarteng’s “mini” Budget was the wrong policy (unfunded tax cuts) at the wrong time (a global crisis). Liz Truss more than shared his folly. She might survive as a figurehead. But she lacks the judgment required of a prime minister. She should go, too. Members of parliament, not party members, should then choose the new leader and prime minister. A general election should follow.

Confidence in the rationality and self-discipline of British policymaking has been damaged, just as trust in the country’s willingness to keep its word was damaged by the desire to break the agreement over Northern Ireland reached so triumphantly three years ago.

To regain that confidence, a return to the status quo ante will be insufficient. Jeremy Hunt, the new chancellor, knows he cannot be sacked. He must now do whatever it takes.

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One reason why a mere reversal will be insufficient is that interest rates have risen, which will raise costs of debt service. A part of this was due to developments in the world, above all the need to tackle the upsurge in inflation. But there is also the impact of the UK-specific shock delivered on September 23rd by Kwarteng’s “mini” budget. It would be optimistic to hope this will simply vanish from people’s minds.

The safest strategy would be to present a credible forecast of declining ratios of debt to gross domestic product in the medium term — credible, that is, to the Office for Budget Responsibility. That forecast must be based neither on unspecified cuts in spending years hence nor on implausible accelerations in the rate of economic growth. This time, the chancellor must eschew fantasies.

It would be a good idea to produce a less-expensive energy package than Kwarteng’s. But that package is a one-off, at least in principle. It is more important to reverse the permanent tax cuts in the “mini” budget. Reversal of the cuts in the higher rate of income tax and corporation tax will be insufficient. The Institute for Fiscal Studies suggests that the permanent fiscal hole, before these reversals, was about 2.5 per cent of GDP. About 1.75 per cent of GDP more tightening is needed (a little over £40 billion a year). That is the least Hunt needs to do if he is to be sure of restoring credibility. He might find he needs to do more.

The big question is how to deliver such a tightening. The chancellor has already suggested that taxes will have to rise and spending will have to be cut. It seems obvious that the greater part of this adjustment will have to be via taxes. It will be extremely difficult to get large spending cuts through parliament, especially since high inflation will reduce the real value of departmental spending substantially. Indeed, rises in nominal spending will be needed, for this reason.

It will surely be impossible to justify large cuts in benefits in real terms in the middle of the cost-of-living crisis. The big public services need to be maintained; indeed, the NHS is already under huge pressure. The government wishes to spend more on defence — rightly so, given the Ukraine war. A government that wants to sustain growth needs to raise public investment, not cut it. Interest costs are also sure to rise. Last but not least, slashing aid would be unconscionable, given how Covid and the war have hit the world’s poorest.

In sum, another round of austerity is both impossible and undesirable.

If the government is unwilling to reinstate all the tax cuts it has made, it needs to find other taxes to take their place. Property taxation could play a part. So could a carbon tax. It is also untrue that higher taxation must kill the economy. What matters is how taxes are raised and what they are spent on.

The Bank of England must similarly show that it will not let the misbehaviour of the government force its hand on monetary policy. That is why it was made independent, after all. Inflation is too high. Policy must address this now. If, as it believes, the pension funds are now reasonably safe, it must stop supporting the gilts market. That should help concentrate minds in the treasury.

The Brexit revolutionaries have increasingly seized control of the country. With Truss as prime minister, they must have thought they had gained a final victory. But they had over-reached instead. Markets have refused to finance their fantasies and opinion polls show that ordinary people have had enough. Maybe the cold water of economic and political reality is at last breaking the UK’s Brexit fever.

— Copyright The Financial Times Limited 2022