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UK financial crisis leaves government credibility in tatters

The new British government’s economic strategy has sparked chaos in financial markets, requiring central bank intervention and earning a stinging rebuke from the International Monetary Fund. But it’s not just the pound’s value in freefall – Conservative Party polling is plummeting too.

LONDON (CN) — The United Kingdom's government is facing a major crisis of confidence amid market turmoil in response to the new economic approach set out by Prime Minister Liz Truss and Chancellor Kwasi Kwarteng.

A "mini budget" released by Kwarteng last week promised to fund 45 billion pounds ($50 billion) worth of tax cuts through borrowing. The announcement immediately triggered a financial crisis that has sent the pound tumbling on foreign exchange markets to some of its lowest levels in history and left the government at loggerheads with the U.K.’s central bank over economic policy, in an extraordinary week in British politics.

Markets are spooked by the new economic direction the U.K. is taking under Truss, who is less than a month into the job. In particular, the massive expansion of borrowing announced by the new government is viewed by lenders as excessively risky and has undermined the U.K.’s reputation for fiscal prudence.

The growing expectation of large interest rates in response to the falling pound poses a danger to the U.K.’s housing market. Highly inflated house prices across the economy mean that many homeowners will be unable to keep up with their mortgage payments in a high-interest environment, risking mass foreclosures.

At the same time, the loss of confidence in the government’s borrowing plans poses a severe risk to pension funds, which are heavily invested in U.K. government bonds.

The sudden uncertainty surrounding mortgages and pensions are hugely disruptive for the Conservative Party’s electoral appeal. The governing party’s primary constituencies among the British public are homeowners and pensioners. By increasing anxiety among these groups, the government is undermining its own electoral base.

And indeed the response from the public has been swift. Polling released by YouGov on Thursday evening put the opposition Labour Party a massive 33-points ahead of the Conservatives – 54% compared to 21%. The last time Labour recorded such a giant lead in the polls was in 1996, just prior to Tony Blair’s historic landslide general election victory.

In that election, Labour ultimately secured a 13-point lead over the Tories. If the polling result from Thursday evening was repeated in a general election, it would spell electoral oblivion for the Conservative Party – a result without precedent in British politics.

The crisis began last Friday, when Kwarteng delivered a so-called “mini budget” to Parliament. In the budget he announced a number of tax reductions, including the scrapping of the top rate of income tax, and the cancellation of a planned rise in corporation tax. The measures are primarily of benefit to high earners, and reflect Truss and Kwarteng’s well-known belief that reducing the tax burden on the wealthy will spur economic growth.

The decision to propose a mini budget, rather than a formal budget, had already sparked controversy. It meant the financial plans could avoid scrutiny from the Office of Budget Responsibility, or OBR. The independent OBR is responsible for formal analysis of government fiscal policy, and for outlining its likely effects on the economy.

Kwarteng had claimed that the OBR would not be able to produce a report on his plans in time. However, the OBR disputes this, saying it would be able to do so and had offered as much to the chancellor.

The uncertainty over the cost of tax cuts, along with the lack of formal government analysis of its impact, sent financial markets into a tailspin almost immediately. Before the chancellor had even concluded his speech, a mass sell-off of government bonds had begun, with widespread skepticism among traders of the sustainability of the mass-borrowing plans being announced.

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Union flags hang along Whitehall in Westminster in London on Thursday, Sept. 29, 2022. (AP Photo/Kirsty Wigglesworth)

The offloading of government debt sent the value of the British currency tumbling to record lows. On Monday, the pound reached its lowest-ever level against the dollar, at $1.03, before staging a modest recovery. The rout on government bonds continued for several days, with their value reaching the lowest level recorded since 2002.

On Wednesday, and amid growing market restlessness, the U.K.’s central bank, the Bank of England, was forced into a dramatic intervention. It announced the purchase of 65 billion pounds ($72 billion) worth of government bonds in order to stabilize the market. It was later revealed that the bank had acted in response to the prospect of an imminent collapse of several major pension funds.

At the same time, fears of large interest rate rises were causing havoc in the British mortgage market. More than 40% of mortgage products have been withdrawn since the mini budget was announced, with fears that house prices could fall by up to 20% as mortgage rates become unaffordable for large swathes of homeowners.

The catastrophic market response was compounded by an intervention from the International Monetary Fund, which issued rare criticism of a developed economy’s fiscal policy.

In a short statement, the IMF warned against the implementation of “large and untargeted fiscal packages at this juncture, as it is important that fiscal policy does not work at cross purposes to monetary policy.”

“Furthermore, the nature of the U.K. measures will likely increase inequality,” the statement added. It urged the government to “consider ways to provide support that is more targeted and reevaluate the tax measures, especially those that benefit high income earners.”

Riding high in the polls, and looking increasingly like a prime minister-in-waiting, Labour Party leader Keir Starmer was unequivocal in his response to the crisis.

“The government has lost control of the economy,” he said. “Unlike other situations where it may be a world event, an unexpected event that causes this sort of crisis, this is self-inflicted. This was made in Downing Street last Friday. And for what? For uncosted tax breaks for those earning hundreds of thousands of pounds."

The view that the government has lost control of the situation is privately shared by a large numbers of Conservative members of parliament, many of whom were already lukewarm supporters of Truss’s project. Some parliamentarians are reported to have submitted internal letters of no-confidence in the new prime minister.

On Thursday, after several days of silence, Truss gave a round of interviews to local radio stations in which she defended her approach. Speaking to BBC Radio Leeds, Truss said, “We had to take urgent action to get our economy growing, get Britain moving and also deal with inflation. And of course that means taking controversial and difficult decisions.”

Truss and Kwarteng have ruled out reversing their flagship tax cuts, in defiance of considerable political pressure. Instead, to calm markets, they have indicated that the scale of planned borrowing may be reduced. A further announcement is slated for Nov. 23, when it is expected that some funding for the tax cuts will be secured through reductions in public spending.

However, austerity measures are unlikely to be a vote winner during a cost of living crisis and a time when the declining availability of public services are a major concern to the public. In particular, waiting times for emergency responses and urgent treatment continue to climb to record levels within the National Health Service.

Truss has long positioned herself as an ardent Thatcherite, leveraging her image as a true believer in market-led macroeconomics to great effect during her prime ministerial bid. Yet it is those very same market forces in which Truss places her faith that have issued a damning verdict on her fiscal approach.

Most ominously for Truss, after just 25 days in the job, there appears to be a lack of confidence shared by her party and by the electorate.

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