Ever since the Brexit vote, financial markets have had an uneasy relationship with the UK. The pound fell sharply after the vote to leave the European Union in June 2016, which surprised many in the City, and since then, UK financial markets have been volatile, trying to price in the consequences of this decision.
While successive governments have blamed the weakness of UK assets on other external factors — and it is true that the Covid pandemic and Russia’s war on Ukraine have depressed financial assets’ prices – the markets sense that since it left the EU, the UK has not been able to regain a sure footing.
Having elected to erect barriers to its exports by leaving the world’s biggest trading bloc, the UK has not yet been able to offer a coherent narrative for its economic outlook. The bright future that was promised before the referendum, when Michael Gove famously said “the day after we vote to leave, we hold all the cards and we can choose the path we want,” seems a very distant prospect.
Liz Truss and her government’s chancellor, Kwasi Kwarteng, seem to be trying to fulfil that promise by putting all their eggs into the same old basket: stimulating the financial and property markets. However, much like alcohol, markets can be a good servant, but a bad master. With his mini-budget, Kwarteng seems to have aimed for the first option but been met with the second.
The government’s decision to cut the top income tax rate by five percentage points to 40% for the highest earners will not cost too much in the grand scheme of things (“only” about £2 billion per year), but it should please those working in financial markets who are among the highest earners.
So should the decision to scrap the cap on bankers’ bonuses, which had been imposed in the wake of the great financial crisis of 2007-2009. The government probably hopes that these wealthy individuals, overwhelmed by gratitude for its largesse, will pour their tax savings back into the financial markets, and this will somehow trickle down to the real economy.
For the property markets, the government doubled the stamp duty exemption on house sales to £250,000. With interest rates on new mortgages rising sharply, the property market was slowing down, so the government probably hopes this will avert a housing market crash.
Together with a reversal of an increase in national insurance and the scrapping of a plan to raise corporation tax by six percentage points to 25% from April, as well as bringing forward a cut of one percentage point to 19% in income tax, this is the biggest set of tax cuts in half a century.
The markets should have celebrated it, because it seems the government has again thrown the kitchen sink to boost financial assets’ prices and real estate. Instead, the erstwhile servant has turned into a master who, for the moment, is punishing the UK government’s bonanza, sinking the pound to a 37-year low against the dollar and selling off UK sovereign debt.
It looks like the government has made a mistake by trusting the markets to fund the big increase in borrowing that its plan entails. Kwarteng probably forgot that around one third of the UK’s debt is owned by the Bank of England, which has already announced plans to start selling it off as part of its fight against inflation.
“Markets move all the time. It’s very important to keep calm and focus on the longer-term strategy,” Kwarteng said in an interview to the Financial Times in response to the market reaction to his mini-budget. The trouble is, it’s the longer-term strategy (and specifically, where will the money come from to pay for the chancellor’s fiscal generosity) that the markets are doubting.