UK Prime Minister Liz Truss scrapped planned tax cuts and sacked her finance minister after an investor backlash threw markets into chaos.
Bianca De Marchi-Pool / Getty Images
The ferocious market reaction to UK Prime Minister Liz Truss' aggressive tax-cutting plan has forced her to ditch most of her proposals and fire her finance minister, Kwasi Kwarteng — all in the space of only a month.
Truss now faces calls to resign, a signal to other world leaders that aggressive economic policymaking in the current climate of fragility can spook investors and cost lawmakers their jobs.
Here's a closer look at what happened in the UK, and what lessons other leaders can learn.
The firestorm was sparked on September 23 by Kwarteng's "mini-budget" of unfunded cuts to taxes on income, corporate profits, and dividends.
Investors feared the cuts would accelerate already-high inflation, force the Bank of England to hike interest rates by more than expected, and blow a hole in the national budget. This, in turn, threatened to worsen the UK's cost-of-living crisis, choke economic growth, and push the country closer to fiscal meltdown.
The British pound quickly plunged to a record low against the US dollar, and yields on UK government bonds, or "gilts," surged to their highest levels since the global financial crisis as worried investors cut their exposure to the country.
The surge in gilt yields also led to a cash crunch in the pensions industry, as funds employing so-called liability-driven investing strategies — hedges against moving inflation and interest rates — were caught off-guard, to the point that some feared pension funds could collapse.
The turmoil spurred the Bank of England to launch an emergency bond-buying program between September 28 and October 14, aimed at stabilizing trading and stopping gilt yields rising further.
"Were dysfunction in this market to continue or worsen, there would be a material risk to financial stability," the UK's central bank said, adding that rising yields could cause credit to dry up for households and businesses.
Truss and Kwarteng's fiscal plans roiled markets, rattled pension funds, and fanned fears of a financial meltdown, and international condemnation was swift. The International Monetary Fund issued a rare public rebuke, advising the UK not to undermine its fight against inflation with looser fiscal policy.
Ray Dalio, the billionaire cofounder of Bridgewater Associates, said the UK's failure to anticipate the brutal market reaction "suggests incompetence." Nobel Prize-winning economist Paul Krugman declared Trussonomics as "deeply stupid" and derided the fiscal plan as "cruel."
Nouriel Roubini, an economics professor at NYU Stern, slammed Truss and her cabinet as "clueless." Mohamed El-Erian, Allianz's chief economic adviser, warned the market mayhem raised the risk of "stagflation" — a toxic combination of stubborn inflation, stagnant growth, and increased unemployment.
Truss fired Kwarteng on Friday and appointed Jeremy Hunt — a veteran politician who has held several top government roles — as her new finance minister.
On Monday, Hunt rushed to reassure markets and the British public that he would get everything under control. He scrapped most of the planned tax cuts and suggested the Energy Price Guarantee — a government scheme to help households and businesses pay their energy bills in the coming years — could be gone by April 2023.
"No government can control markets, but every government can give certainty about the sustainability of public finances, and that is one of the many factors that influence how markets behave," Hunt said.
"Governments cannot eliminate volatility in markets, but they can play their part," he added, noting instability affects prices for consumers, mortgage costs, and the value of pensions.
The government has now walked back about two-thirds of the £45 billion ($50.9 billion) tax cuts it initially planned, according to the Institute of Fiscal Studies, a UK think tank.
The UK's experience shows that spooking markets with aggressive policymaking can have consequences.
Shifts in stock, bond, and currency prices signal where investors' fears lie and what they expect to happen. These fears tanked the pound, raised the government's borrowing costs, and heaped pressure on pension funds. As such, Truss has been forced to walk back most of her plan, replace her finance minister, and fight for her job.
Her U-turn was "even more historic than the initial mini-budget," Craig Erlam, a senior market analyst at Oanda, said in a note this week. "A humiliating moment after a chaotic period for Truss in which confidence in her in the markets, the public and her own party, it seems, has been decimated."
El-Erian tweeted on Monday: "It's interesting to hear that some European officials are welcoming the 'demonstration effects' of the UK policy U-turn, seeing it as vividly illustrating to some EU member countries the danger of fiscal slippages."
The key takeaway may be that in a period of sky-high inflation, flagging economic growth, and geopolitical tensions, leaders can make few good choices.
Raising rates may cool inflation, but it can also reduce people's wealth by reducing the value of their homes, investment portfolios, and other assets, as well as increase unemployment. Meanwhile, letting inflation run riot squeezes people by making goods and services more expensive, and makes it harder for investors to earn real returns on their money.
UK leaders thought they could grow their way out of trouble by slashing taxes — but were swiftly rebuked by skeptical investors. Their peers abroad will now surely be wary of incurring the wrath of the markets and putting their careers at risk.
