The last few days have been one of those weeks when decades happen with the Government’s mini-budget provoking a sharp fall in sterling against the dollar, an even more dramatic rise in the yield on government debt and a consequent sudden intervention in the bond market by the Bank of England. Not surprisingly, following this chaos, there have been a slew of polls revealing a collapse in Conservative support and leads for Labour of a size last seen before their 1997 landslide. So, what happened? To understand we need to untangle short-term and local political incompetence and longer-term structural problems. The latter are more alarming and should be concentrating minds in the Labour leadership as well as the Government.

The budget derived from a strategy and vision that Liz Truss clearly set out during the Conservative leadership campaign. The diagnosis is that the U.K. faces stagnation because of a lack of structural reform and economic dynamism, with drastic action needed to correct this. The prescription is cuts in taxation and deregulation, to stimulate more entrepreneurialism and economic growth. Growth is made the goal and central focus of policy, with the belief that this will make almost every other problem easier to manage – or that these challenges are impossible to meet without growth. The idea is that these cuts and deregulation are combined with other supply side reforms, such as changes to trade union law and reform of the land-use planning system. Crucially, reduction in the level of government spending was not seen as the other side of the package – it was planned for as an eventual outcome but in the meantime a relaxed view was taken of a continuing large budget deficit (this was the key point of difference with Rishi Sunak). The meant the final part of the programme was a rise in interest rates and tightening of monetary policy, to control inflation and attract the funds needed from lenders, in the short run.

Whether you agree with it or not, this was a coherent policy. So where did it all go wrong? There are answers: it was done in a way that was politically naïve, it was presented in a way that put the cart before the horse and conveyed a justified impression of cavalier insouciance, and it was in any case fundamentally unrealistic given the present situation and the U.K’s global position. A key point to emphasise is that this was not, despite much excited comment, a Thatcherite budget. The analysis and strategy actually came from the early part of Ronald Reagan’s presidency – this was a “supply-side” programme similar to the one pursued in the early 1980s (which saw cuts in taxes but no reductions in spending and a consequent ballooning budget deficit).

The first problem was that the political optics were terrible and the presentation lamentable. To borrow billions of pounds to fund tax cuts and particularly tax reductions for the really well off is a seriously bad look at any time but particularly when most households are facing a big rise in costs due to inflation, a reduction in real wages, and a massive rise in energy bills. The market reaction was not primarily driven by that perception though. The more serious problem was that the budget did not follow a detailed and worked out exposition of the government’s strategy and goals or of metrics by which it could be judged, and quantitative assessments of the impact of the measures it contained. These were deliberately avoided. This created an impression of reckless insouciance. 

This was magnified enormously by the context and the actual primary content of the budget that it led to. This was the massive rise in energy costs and the (inevitable) response of the government to take on huge borrowing to cap the unit price of energy (not, as the PM herself apparently thinks, to cap household bills). The meant the government was already committed to an enormous amount of borrowing with an apparently open-ended commitment if energy costs remained high. In this context, the scrapping of the planned tax increases to corporation tax and national insurance made sense and would not have spooked traders. Combining that with getting rid of the 45 pence rate and announcing a one pence reduction in the standard rate was seriously reckless, given other things not said or done.

Not only was the government’s strategy not spelt out in detail in advance, no serious supply side reforms were detailed – there were promises of various reforms but nothing detailed, and major measures, above all reforming the planning laws, were lacking. The impression was that the government thought is could cut taxes and be relaxed about massive and rising borrowing because the tax cuts themselves would lead to a rise in growth that would make them self-financing. Not only was no evidence presented from bodies like the OBR to support this, the problem was that there is no evidence for this. It was an act of faith not evidence-based judgment. 

All this can be summarised by saying that the PM and Chancellor were guilty of going for the jam of tax cuts before doing the hard work of the supply side reforms bread and butter – or even setting out in detail how they aimed to do this. They jumped the gun in other words. There was no way that the markets would tolerate this. The key point here was that this Reagan-style strategy would not work for the U.K in the way that it did in the US because the two countries are not in a comparable position. Above all the U.K does not enjoy the “inordinate privilege” of issuing the world’s reserve currency and so has to pay far more attention to what international lenders think, not least because it has a large current account deficit relative to GDP. That means it has to import a matching amount of capital to fund its net imports and so it is dependent on the confidence of foreign holders of sterling.

That brings us to the final missing piece of the jigsaw. The strategy of the budget necessarily meant a rise in interest rates, to control inflation and to attract buyers for government debt. If fiscal loosening was one part of the strategy, tighter money was the inevitable complement. However, the day before the budget the Bank of England only raised interest rates by 50 basis points instead of the widely expected 75. This followed three consecutive 75 point rises from the Federal Reserve (with another to come) and a year of foot-dragging by the Bank over raising rates. This meant that sterling came under immediate pressure and bond yields rose as traders anticipated (and looked to force) a rise in interest rates. The Chancellor then compounded the problem over the weekend by saying there were more tax cuts to come while saying nothing about either monetary tightening or other steps to reduce the level of borrowing if that was not tightened enough.

All of this led to mayhem in the currency and bond markets and the central bank’s intervention. The level of naivety, of the kind associated with student union politics, infuriated markets even more than they would have been anyway. Clearly what the Government should have done was not prematurely announce tax cuts and go for a Reginald Maudling or Anthony Barber style “dash for growth”. It should have confirmed the energy support package, reversed the planned tax increases, and announced a major statement of economic strategy and a full, costed, package of both fiscal measures and supply side reforms for later in the year. Instead, it used the opportunity to send a message about its intentions and shake things up by announcing tax cuts funded by further borrowing. It certainly sent a message and shook things up but not in the way it intended or expected.

At this point some will say that this all overblown, with the pound having more than recovered and the bond market having stabilised. This is premature and also misses the structural situation that now faces any British government in the next decade at least. The Bank of England has calmed the bond market by suspending its planned unwinding of QE (which will reduce the money supply) until 13th October and buying gilts to stabilise their price at the Treasury’s expense (so adding to the deficit). When that date arrives, the markets will reasonably expect the kind of statement they should have got before the budget. If it is not forthcoming the pressure will resume. There are also several points to take away from all this.

Firstly, that U.K. governments are severely constrained in the range of options open to them, by the country’s actual geopolitical and economic position. It is not the United States and acting as though it is will not end well (this is true for other aspects of politics as well). Secondly, any government faces serious political difficulties. It is right to try to make growth the priority but the supply side reforms that requires will be very unpopular, not least with Conservative votes (given that the most important one is to reform the planning laws and reduce both rents and house prices, which will enrage many homeowners). Thirdly, any policy that aims for growth and does not involve a reduction in the size of government will mean higher interest rates – which are going to happen anyway for reasons beyond the control of any British administration or the Bank of England. This will inevitably reduce economic activity in the short term and make growth less likely for that time. It will also be very painful, however necessary or inevitable, because of serious problems of excessive borrowing by both households and firms brought about by many years of depressed rates.

Finally, the global and longer term context means in addition that the next government (almost certainly now a Labour one) will face a very difficult situation. Energy costs, which played a key part in the last few days, will not fall any time soon but will remain elevated for several years. This is due to the nature of the world’s energy supply position (which was leading to a rise in oil and gas prices before the Russian invasion of Ukraine) but also because the destruction of the Nordstream pipelines mean that Europe will face a shortfall of gas for several years and will have to make it up with more expensive imports. This will ease as infrastructure is built but that will take several years. 

Meanwhile the over forty year bull market in bonds and the associated secular decline in interest rates have clearly ended this year. This means that regardless of what the U.K. does, interest rates will be on an upward path. The days of cheap money are over and this means a painful reckoning and adjustment for both households and companies but also for governments. The latter will be faced with the challenge of meeting large unfunded liabilities and also major demands for investment to deal with climate change, at a time when the cost of government borrowing will be rising. A debt crisis is inevitable unless there is sustained inflation which would bring its own problems.

Steve Davies is Head of Education at the Institute of Economic Affairs in London. He is the author of Empiricism and History (Palgrave Macmillan, 2003), The Wealth Explosion: The Nature and Origins of Modernity (Edward Everett Root, 2019), The Economics and Politics of Brexit (AIER, 2020) and The Streetwise Guide to the Devil and His Works (Edward Everett Root, 2021).