Who can explain financial markets’ hatred for the new UK government?

by philg

There has been a lot of drama in the currency and bond markets regarding the new UK government’s economic policy, which sounds like it is along the lines of what the U.S. did in the 1980s. President Ronald Reagan proposed shrinking government with spending cuts so that tax cuts could be implemented; Congress agreed to the tax cuts, but refused to cut spending and the result was massive deficits, which eventually faded due to economic growth.

The UK government is already somewhat leaner than what we have in the U.S. Heritage says that the UK government consumes 42 percent of GDP, which is a touch higher than the US government (39 percent), but the UK figure includes nearly all health care spending. If we add government-mandated-and-regulated “private” health care to the US number, we get closer to 50 percent of GDP.

The business folks and investors with whom I spoke in the UK were generally positive regarding Prime Minister Truss‘s plan, which they felt would deliver a substantial amount of growth. They attributed much of the hatred and hysteria to an anti-Conservative press. On the other hand, hatred and hysteria in currency and bond markets isn’t usually driven by whatever the Guardian has to say.

One part of Truss’s plan seemed insane to me, i.e., preventing consumers from seeing that prices for energy have gone up. But the French are also doing it. Wholesale electricity prices are up 5X and consumers are paying… 1X. Party On with printed money.

“Liz Truss’s economic plan caused a furor. But it’s actually sound” (Washington Post, October 9):

Britain is the only Group of Seven country with a smaller economy today than in the fourth quarter of 2019, before the coronavirus pandemic. In the 40 quarters preceding the pandemic, its economy grew at an annual rate of less than 2 percent more than half the time.

Maybe a country where all of the young people get stumbling drunk every night at the pub isn’t ideally situated for growth?

The government’s tax plan would cancel a scheduled increase in the corporate tax rate to 25 percent from 19 percent and would make permanent a temporary increase in the annual investment allowance, letting businesses deduct the full cost of qualifying plants and machinery up to 1 million pounds in the first year.

This sounds reasonable to me! With a 25 percent rate, a company would have to be crazy to refrain from pushing all of the profits into Ireland (12.5 percent rate and full membership in the EU if frictionless trade with Europe is required). The depreciation simplification should front-load investment and activity and shouldn’t change the tax owed in the long run (spending one million pounds will yield one million pounds of deductions against revenue).

The most questionable parts of the plan are the income tax cuts. Reducing the basic rate of income tax by one percentage point, to 19 percent, will fuel consumption at a time when the Bank of England is attempting to curb inflation.

The prime minister’s proposal to eliminate the 45 percent tax bracket on incomes above 150,000 pounds per year — the top 1.1 percent — was also unwise in the current fiscal and economic environment, …

I’m not sure that a 45 percent rate is revenue-maximizing. At that rate, a Brit would get a great return on pushing activities offshore or structuring activities to get the 10 percent entrepreneur’s rate. The U.S. government is greedy for money and the top personal income tax rate is 37 percent (which works out to 37 percent in Florida or 50.3 percent in California).

It looks like the markets are locking Britain into the same policies that put it on the slow bus to economic mediocrity. Given some reasonable value placed on leisure and drunkenness, the decision to forgo the second job or language study and spend the evening in the pub with friends will be a rational one. For those who are ambitious, the decision to emigrate will likely be a rational one (one of our neighbors in Florida recently arrived from the UK, having accepted a transfer within a multinational industrial products company (held up for more than a year due to coronapanic restrictions on non-walk-across-the-border-and-claim-asylum immigration); he will do the same thing that he did in the UK, but for a much larger market).

What am I missing? My default assumption is that markets are right, but I can’t figure out what is so terrible wrong with the latest British government’s plans. Is part of the explanation that the pound isn’t the world’s reserve currency and therefore the consequences of deficit spending are more severe than they are for the U.S.?

Separately, how can a country full of midgets and randoms fail to thrive?

25 thoughts on “Who can explain financial markets’ hatred for the new UK government?”

  2. Must be the uncapped energy subsidy that leaves folks unaware and indifferent to how much gas/electricity they use. UK must be more vulnerable to gas price spikes than France with their nuclear power plants. Germany is doing 200B euro energy subsidy and that’s just supposed to last a year or so..

  3. Let me try. Just by subsidising energy to the public alone, the UK gov will get in massive debt. I am sure other spending avenues will be found to increase any debt, outside energy subsidies. The markets just believe that (1) the debt will increase much much faster than any *potential* benefits the cuts will provide, and (2) they believe the UK economy does not have a good medium and long term prospective, no matter the policies implemented, so why take the risk.

    • Thanks, F, for the on-the-scene reporting (you live in the UK, right?). The energy price subsidies are incomprehensible to me. Like something Venezuela might do or maybe Saudi Arabia.

    • Nope, I do not live in the UK, but I did for 16 years. In any case, you said yourself: the lowest tax rate proposed by Truss was *higher* than the rate in Ireland, with access with a smaller market, so the tax cut would guarantee a net income loss without any guarantee the economy would increase (and absolutely no way to guarantee that any economy increase would make up for the increased deficit). If a company is in the UK it is not for the tax rate, that’s for a fact.

    • Federico: If companies stayed in the UK despite the 20 percent tax rate when Ireland’s rate was 12.5 percent implies that corporates are indifferent to corporate tax, the logical response is to raise the corporate tax rate to 99 percent, not to a feeble 25 percent. If it has been proved “If a company is in the UK it is not for the tax rate, that’s for a fact”, shouldn’t the UK corporate tax rate be commensurately high? It’s a fact that companies are staying headquartered in the UK for reasons that have nothing to do with the corporate tax rate so they won’t move or shift income to exotic offshore structures if the rate is raised.

    • Phil, let’s keep it within the bounds of reasons. Indifference to the current tax and market situation does not equate to indifference to any tax and market situation. But clearly there are companies that choose the current UK tax/market situation, thus making your argument that they would immediately run to a ‘better’ situation empirically false.

      The fact a company is in the UK despite higher taxes and smaller market shows that the current higher taxes and smaller market are acceptable, for reasons each company would have to articulate (if they care to do so) for themselves. Whether the same companies would stay around at a higher tax rate — who knows? it can be empirically tested though.

    • These tax nerds say that when the UK had a tax rate of 28 percent, there was a huge rush to invert into Irishness:

      https://taxfoundation.org/tax-reform-uk-corporate-tax-inversions/

      So somewhere between 20 percent and 28 percent was apparently the tipping point back when the UK was part of the EU.

      When rates are higher than 15-20%, I think we can’t underestimate the possibility of multi-national corporations finding ways to pay a country 0% instead of whatever the headline rate is. There is a good graphic in https://www.nytimes.com/2012/04/29/business/apples-tax-strategy-aims-at-low-tax-states-and-nations.html

      direct link to the graphic:

      https://archive.nytimes.com/www.nytimes.com/interactive/2012/04/28/business/Double-Irish-With-A-Dutch-Sandwich.html?ref=business

      https://en.wikipedia.org/wiki/Double_Irish_arrangement says that the 2017 Trump tax law changes were supposed to end the party, but that “technical flaws in the TCJA had increased the attractiveness of Ireland’s BEPS tools, and the CAIA BEPS tool in particular, which post-TCJA, delivered a total effective tax rate (“ETR”) of 0–2.5% on profits that can be fully repatriated to the US without incurring any additional US taxation”.

  4. I can’t speak for the UK, but in Germany subsidies have a way of going to friends and family. That is why we always need a new crisis.

  5. Government does not OWN anything. Everything government has was taken from citizens by force or threats of force.

    So… government “subsidies” are just taking from some people (by force) and giving to others. Pretending that the subsidies will help with energy costs is beyond naive. It’s plain retarded.

    And, no, funny games with numbers (money printing, government “borrowing”, etc) are just that – games. These do not create any real resources or wealth. All they do is moving wealth from middle and low classes into pockets of financial “elite” and other political cronies. See: Cantillon effect.

    • disevad: I realize that is a rhetorical question, but to spell it out:

      The U.S. does not want Europe to buy gas from Russia directly, and Russia does not want a Trans-Caspian Gas pipeline (but does want to maintain its influence around the Caspian Sea). Which is the whole rationale for the NATO expansion threats, escalation, war, etc.:

      https://www.heritage.org/europe/report/time-us-strategy-the-caspian

      The German “Green” party (currently in power) is part of the Atlantic Rainbow Coalition and has always supported the destruction of Nord Stream (far before 2022). It prefers shipping overpriced LNG around the globe.

  6. London’s City is too large part of UK economy and definitely promotes both anti-meritocracy and cronyism,. It seems to attempt or at least be proponent of social engineering.
    Idk but it likely may depend on central policies and like big government; it sure did well why UK overall “stagnated sideways”. When and if Truss selects able cabinet bent on reducing economic regulation and removing barriers to work and when and if British public will respond to it the market will turn around, large and institutional investors can not bear to loosing money for long, how would then they fund idiotic social engineering?

  7. The government spent £400bn of non-existent money with no apparent qualms from the market to alleviate what was perceived as a once-in-a-lifetime crisis; wishful groupthink led to inadequate central bank action in the face of subsequent inflation (shown up even by the Fed); then an undeniable once-in-a-lifetime crisis turned up, but apparently being on the verge of a nuclear war wasn’t seen by the markets as a reason for more long-term borrowing.

    While BJ was “in charge” the government was like Wile E Coyote over the cliff edge but hanging in the air with legs pumping. Traders coming back from their summer holiday flipped the mental switch, a phase change if you will, bringing Coyote crashing down.

  8. I am not really into British markets and my guesses are based on a decade – old indirect and direct experiences and tracking / fixing issues caused by general policies and direct actions originated from London Financial City / financial governance. Here is the current take, in the clip at 5m 33 sec. “…people are criticizing Liz Truss and the Bank of England for simultaneously pursuing both a stimulatory policy and a let’s raise interest rate[s] policy. That’s what this administration’s done…”
    https://www.breitbart.com/clips/2022/10/15/cassidy-biden-has-the-same-contradictory-economic-approach-that-the-uk-is-getting-bashed-for/

  9. It would have been preferable if you had clearly identified the markets’ supposed hatred for the Truss plan — which markets and when? There is a lot of noise in the media but like with Brexit the noise tends to mask a relatively stable reality. So a quick look at US and UK ten year bond yields seems to show that both shot up starting the end of August presumably as markets decided that “team transitory’s” view of the world was inaccurate. The graph of ten year gilts seems to show that what happened over the last couple of weeks was insignificant in comparison.

    An observation on tax rates in Britain, Britain does not tax world wide income so it is easy for the UK wealthy to stash money offshore – which is why the offshore tax havens in the Caribbean, the Channel Islands and the Irish Sea exist. So it is dubious that wealthy Brits (& the wealthy on the Continent) are really paying the headline numbers.

  10. True, but as soon as a UK national returns to Britain for more than a short visit worldwide income and assets are in play again (see link). This might make, or have made, sense if the country wants to encourage its people to go abroad and make money/rape and pillage/keep the peace in South Asia/stop the colonists from seizing treaty-protected native lands/etc.

    Foreign nationals who move to Britain, like the wife of the third last Chancellor, can pay protection money to avoid taxation on their worldwide income and assets in the UK. At the least, this is meant not to disincentivise Elon Musk types from coming to Britain to invest and defray their fortunes.

  11. Sometimes it helps to tell the eggheads that they’re missing the point entirely, which I think most of the eggheads here are doing: the bottom line is that Biden is a Europeanist and he didn’t like Truss’ plan, and that was the end of that. He said he thought it was a mistake, went so far as to say it was “predictable” and now he’s been proven correct. It’s just that simple.

    There is absolutely no way anyone in Europe (or Biden in the United States) was going to do anything but oppose her though backchannel and front channel means. I’m surprised it lasted as long as it did, particularly after Italy elected a Far Right Whacko and put the scare into everyone real good like. You folks are all overanalyzing it – that’s what you’ve been trained to do, but it often has little to do with How Things Work.

    He made those comments at a Baskin Robbins ice cream shop in Oregon. His former boss once worked at a Baskin Robbins in Honolulu:

    https://www.businessinsider.com/barack-obama-lessons-from-first-job-scooping-ice-cream-2016-2

    “My first summer job wasn’t exactly glamorous, but it taught me some valuable lessons,” Obama said. “Responsibility. Hard work. Balancing a job with friends, family, and school.”

  12. Hi Phil,

    Please recall that bond prices fall as yields rise.

    I believe vast majority of UK pensions, endowments, and insurers were sitting on large, yet unrealized losses in Gilts (British equivalent of treasuries) and other quasi fixed income instruments like Mortgage Backed Securities and yield-linked derivatives (so called LDI’s) .

    Such losses were deferred in the hope that Bank of England (BoE) or some other Central Bank would bail them out, as in 2008, and to a lesser extent in 1998, and resume purchasing Gilt. See time series below for Bank of England’s continuous purchases of Gilts from 2008-2021. BoE now owns 37% of Britain’s sovereign debt.

    https://www.ons.gov.uk/economy/governmentpublicsectorandtaxes/publicsectorfinance/timeseries/mex2/pusf

    Truss’ plan to reduce collections and expand deficit (at least in short term), would have resulted in additional issuance of Gilt, and presumably even lower prices, since the BoE had stopped buying.

    *At the margins* some of the institutional owners of Gilts started selling, only to find the bid side of market thin and illiquid.

    This is what happens when the central bank owns 37% of the outstanding bonds, as it does in the UK.

    In plainer English: very few private buyers of Gilts, no public buyers of Gilts, and trying to unload even small quantities resulted in disproportional changes in price, leading to worse marks-to-market. Which brought out more sellers and forced liquidators.

    At which point the Bank of England stepped in by resuming purchases if Gilts and preventing the bond market from finding a clearing price.

    Had absolutely nothing to do with tax policy per se and everything to do with market dynamics (positioning, size, and socialization of private losses)

    • Rellag: Thanks for this explanation! It definitely sheds some light on how the reaction could have been so extreme to what, other than the energy subsidies, didn’t seem like crazy policies.

    • @Rellag: Thank you. I appreciate that explanation a lot. Why someone doesn’t illustrate this with a few PowerPoint slides and explain them on television bothers me.

    • @philg and @alex

      Thanks for the kind words.

      The interesting (to me) followup question is how liquid and deep the US Treasury market is after a decade and a half of the Federal Reserve being the largest bidder See FDHBFRBN series below.

      https://fred.stlouisfed.org/series/FDHBFRBN

      Fed holds about 20% of US Federal Debt, so not as bad as either UK or Japan.

      Offset by the fact that face value of US Federal Debt is 2.5x-ish UK and Japan sovereign debt combined..

      Wouldn’t take a lot of sellers.

      I didn’t think Margin Call was a great depiction of how a Wall Street firm works, despite the appropriate and realistic portrayal of a well-dressed MIT Course 16 grad as the hero/protagonist but I do endorse the following scene with Jeremy Irons as the boss-from-London-branch.

      https://www.youtube.com/watch?v=Z8YcETTeRbs

      If things turn out badly over next 90-180 days, it will start in the sovereign debt markets.

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