Liz Truss has been prime minister for less than a month, and her government’s economic programme has already produced one of the most dramatic confrontations between politics and financial markets Britain has experienced in years.
On 23 September, Chancellor Kwasi Kwarteng presented what the government called a “Growth Plan”. The package contained large tax reductions, including reversing the recent National Insurance increase, cancelling a planned rise in corporation tax and abolishing the 45% additional income-tax rate paid on the highest incomes. Combined with other measures, the package represented roughly £45 billion in tax cuts without equivalent immediate reductions in government spending.
The government’s economic argument is that Britain has suffered from insufficient growth and that lower taxation can improve incentives for investment, entrepreneurship and work. Truss and Kwarteng want to shift economic policy away from managing the existing distribution of income and towards increasing the economy’s productive capacity.
That is a legitimate economic argument.
Financial markets have responded as though they are not convinced the government’s arithmetic is credible.
Sterling fell sharply after the announcement and briefly reached a record low against the dollar early on Monday. British government bond yields rose dramatically, increasing the cost at which the state can borrow. Mortgage providers withdrew products as expectations for interest rates changed. By Wednesday, the Bank of England had announced temporary purchases of long-dated government bonds after warning that dysfunction in the gilt market posed a material risk to UK financial stability.
In less than a week, a fiscal announcement intended to demonstrate a new government’s economic confidence instead produced a crisis of confidence.
The easiest interpretation is that financial markets have “rejected” Truss’s economic policy.
That description is useful but also politically dangerous because markets do not vote.
Nobody elected a bond trader.
A hedge-fund manager does not possess more constitutional authority than a British citizen simply because they manage billions of pounds.
If democratic government means anything, elected politicians must retain the ability to pursue economic policies that investors dislike.
But democracy does not abolish scarcity, arithmetic or voluntary exchange.
A government can decide how much it wants to borrow.
It cannot unilaterally decide the interest rate at which other people are willing to lend.
That distinction may explain most of what has happened this week.
Britain regularly spends more than it receives in tax revenue and therefore issues government bonds to finance the difference and refinance existing obligations. Investors purchase those bonds because they expect the British state to repay them and because gilts are normally regarded as relatively safe assets.
The interest rate demanded by investors depends partly on expectations about inflation, monetary policy, future government borrowing and the probability of repayment.
Britain is not remotely close to an ordinary sovereign default in the way Sri Lanka has been this year. It issues debt in its own currency, possesses deep financial markets and has a powerful central bank.
But investors still care about the future path of borrowing and inflation.
If the government announces substantial permanent tax cuts without simultaneously explaining how expenditure or future revenues will adjust, expected borrowing rises.
More borrowing means more bonds need to be sold.
Investors may then demand higher yields.
This is not necessarily ideological punishment.
It is pricing.
That difference matters.
Imagine the government announced tomorrow that every British household would receive £100,000 financed entirely through new borrowing. The policy would probably be popular with recipients. Parliament could theoretically authorise it.
The fact that the decision was democratic would not make the resources free.
Someone still has to purchase the debt.
Inflation might rise.
Interest rates might change.
The exchange rate might fall.
Economic constraints do not disappear when a policy wins an election.
Democracy determines who makes collective choices.
It does not determine the physical consequences of those choices.
This is where political sovereignty encounters economic interdependence.
Britain possesses sovereign authority over taxation.
It does not possess sovereignty over the preferences of every person holding pounds or gilts.
Investors can sell.
Companies can move capital.
Consumers can purchase foreign currencies.
Banks can change mortgage rates.
Those responses become part of the policy environment.
Governments therefore operate inside systems containing actors they do not control.
This is sometimes described as the discipline of markets.
The phrase can sound almost virtuous, as though financial markets are wise institutions correcting irresponsible politicians.
They are not.
Markets can panic.
Investors can herd.
Assets can become mispriced.
Financial institutions can create enormous systemic risks, as 2008 demonstrated rather clearly.
But markets do aggregate information about what people are willing to risk their own money on.
When thousands of investors simultaneously demand higher compensation for holding British government debt, policymakers should at least ask what information the price movement contains.
Ignoring the signal because traders are unelected would be as foolish as treating the signal as infallible because traders have money.
The correct response is interpretation.
What changed in expectations?
Part of the answer is the scale and presentation of the government’s fiscal programme. The tax reductions arrived alongside enormous government support for household and business energy bills, which itself could cost tens of billions of pounds depending on future energy prices.
That means the government is simultaneously reducing some revenues and accepting large new expenditure commitments.
Either policy can be defended individually.
Together they create a larger financing requirement.
The government’s answer is growth.
If lower taxes substantially increase economic activity, future tax revenues can rise and debt can become easier to manage relative to GDP.
This is the logic behind supply-side economics.
The problem is timing and magnitude.
Tax cuts occur immediately.
Growth effects are uncertain and arrive later.
Debt markets therefore have to finance the gap before anyone knows whether the growth materialises.
That makes credibility essential.
A government cannot simply announce that a policy will raise growth and treat the forecast as revenue.
Investors need to believe the mechanism.
This is where the absence of an accompanying forecast from the independent Office for Budget Responsibility has become politically significant. The OBR exists partly to reduce the temptation for governments to produce excessively optimistic assumptions about their own fiscal policies.
Independent fiscal institutions solve an information problem.
Politicians have incentives to say their policies will work.
Opposition politicians have incentives to say they will fail.
An institution separated from immediate electoral competition can provide another estimate.
It will not always be correct.
Its value comes from reducing the government’s ability to mark its own homework.
This is another example of political actors voluntarily accepting constraints in exchange for credibility.
Governments often dislike independent institutions precisely because those institutions can obstruct preferred policy.
But that obstruction can increase the credibility of the policies that survive scrutiny.
Central-bank independence works through similar logic.
A government might prefer lower interest rates immediately before an election because cheaper credit can stimulate demand.
If voters and investors expect politicians always to manipulate monetary policy for short-term advantage, inflation expectations can rise.
Delegating interest-rate decisions to an independent central bank sacrifices some direct democratic control in exchange for greater confidence that monetary policy will pursue longer-term price stability.
Again, political power can become more effective when politicians surrender part of it.
Britain’s current crisis demonstrates what happens when fiscal policy and monetary policy begin pulling in opposite directions.
The Bank of England is trying to reduce inflation, which is already extremely high. That generally requires tighter monetary conditions.
The government has announced a large fiscal loosening through tax cuts and energy support.
One institution is pressing the brake while another presses the accelerator.
The analogy is imperfect, but the policy tension is real.
If fiscal policy increases demand while inflation remains high, the Bank may need to raise interest rates more aggressively than otherwise.
That creates distributional consequences.
A household may receive a tax reduction and then face a substantially larger mortgage payment.
Government policy therefore cannot be evaluated by looking at the tax side alone.
Macroeconomic systems respond.
The pound matters for similar reasons. Britain imports large quantities of goods and energy. A weaker pound makes many imports more expensive in sterling terms.
That can intensify inflation.
The exchange rate therefore becomes a transmission mechanism between fiscal credibility and household living costs.
Again, an abstract market number becomes political very quickly.
A currency falling from one exchange rate to another sounds like something happening on Bloomberg terminals.
Then petrol, food, imported components and foreign holidays become more expensive.
Macroeconomics eventually reaches the kitchen table.
This is why economic credibility is a political resource.
Governments often speak about credibility as though it is a judgement delivered by experts in London or New York.
Citizens experience it through borrowing costs, employment, prices and taxation.
The Bank of England’s intervention on Wednesday makes the relationship even more complicated. The Bank announced temporary purchases of long-dated government bonds because severe market movements were threatening financial stability, particularly through stresses affecting pension funds using liability-driven investment strategies.
At first glance, the intervention appears contradictory. The Bank is trying to tighten monetary policy to control inflation while simultaneously buying government bonds, an action normally associated with monetary easing.
But the objectives are different.
One policy targets inflation over time.
The emergency purchases target dysfunction in a particular financial market.
Central banks can therefore tighten overall monetary conditions while providing temporary liquidity or market support to prevent a financial mechanism from collapsing.
This is an important distinction because policymaking becomes confusing when one instrument is assumed to have only one meaning.
Buying bonds does not always mean “stimulus”.
Raising taxes does not always mean “austerity”.
Cutting taxes does not always mean “growth”.
The economic effect depends on context, expectations, financing and what else is happening simultaneously.
That is precisely what makes slogans so inadequate for macroeconomic policy.
Truss’s government appears ideologically committed to lower taxation and faster growth.
There is nothing inherently irrational about that objective.
Britain has experienced weak productivity growth for years, and improving investment and productive capacity should be a central economic priority.
The question is whether unfunded tax reductions are the most effective mechanism for achieving it, particularly while inflation is high and monetary policy is tightening.
That is an empirical question.
Ideology can identify what outcomes a government values.
It cannot determine the size of a fiscal multiplier or the elasticity of investment with respect to corporation tax.
Those require evidence.
This is where political conviction can become dangerous when it treats disagreement from markets or institutions as proof that reform needs to become even more radical.
Sometimes opposition reflects vested interests.
Sometimes it contains information.
A competent government needs to distinguish between them.
The distribution of the tax cuts also matters politically. Abolishing the 45% additional rate primarily benefits very high earners at a time when millions of households are struggling with energy bills and inflation.
The government’s argument is that improving incentives for high earners and investors can increase growth that benefits the broader economy.
Critics describe the package as regressive and question whether those growth effects will be large enough.
This is not merely a technical dispute.
It concerns how governments value efficiency and distribution.
A policy can increase total output while increasing inequality.
Another can reduce inequality while lowering some incentives for investment.
Economic policy then requires a normative judgement about the trade-off.
Economics can estimate consequences.
It cannot tell society how much inequality is morally acceptable.
Elections partly perform that function.
But again, electoral authority does not make the government’s economic assumptions correct.
A majority can legitimately choose a policy that later performs badly.
Democracy gives citizens the right to make collective mistakes.
Markets do not possess a constitutional right to veto those mistakes.
They do possess the ability to change prices in response.
This distinction is essential to the question of whether Britain is being “governed by markets”.
If Truss changes policy because bond yields rise, one interpretation is that unelected investors have overruled democracy.
Another is that the government has received new information about the cost of implementing its policy and rationally updates.
The second interpretation seems more convincing to me.
Suppose a government promises to build a railway for £10 billion and later discovers construction will actually cost £40 billion. Reconsidering the project does not mean construction companies have overruled democracy.
The cost changed the calculation.
Interest rates are a cost too.
A fiscal programme that appears sustainable when government borrowing costs 2% can look very different when borrowing costs 5%.
Markets change the price at which the policy can be financed.
Government still decides whether to pay it.
This is why sovereignty should not be confused with immunity from consequences.
Britain is sovereign enough to borrow as much as parliament authorises.
It is not sovereign enough to require everyone else to lend cheaply.
Sri Lanka demonstrated the extreme version of this problem earlier this year. Its government eventually ran out of sufficient foreign currency to finance essential imports and debt obligations.
Britain’s institutional and monetary position is radically stronger, so comparisons should not be exaggerated.
But the underlying principle is universal.
Governments have budget constraints.
Countries can postpone them, refinance them, inflate parts of them away or redistribute them.
They cannot repeal them.
Political movements sometimes gain support by promising that constraints themselves are inventions of previous governments or orthodox economists.
Occasionally orthodoxy is wrong.
Economic history contains plenty of examples where conventional thinking deserved challenge.
But challenging a constraint requires evidence that the constraint is misunderstood, not merely confidence that it would be convenient if it disappeared.
The Truss government is attempting an unusually rapid experiment in supply-side fiscal policy.
Markets have responded with an unusually rapid judgement.
Neither is necessarily the final word.
Sterling can recover.
Bond yields can fall.
Growth may improve.
The government may alter the package.
As of tonight, we do not know the eventual outcome.
That uncertainty should remain central.
What we do know is that credibility can disappear much faster than it is accumulated.
Britain spent decades developing a reputation for relatively predictable economic institutions, an independent central bank, transparent fiscal processes and deep government-bond markets.
One fiscal announcement was enough to make investors reassess part of that reputation.
This is why institutional capital behaves like trust more generally.
Building it is slow.
Spending it is fast.
Governments should therefore distinguish between policies that merely use fiscal resources and policies that use credibility.
Borrowing to respond to a pandemic can increase debt while markets still understand the temporary reason for borrowing.
Announcing large permanent tax cuts without a detailed accompanying fiscal plan asks investors to make a much larger assumption about future growth or future spending restraint.
The government is borrowing credibility against an economic outcome that has not happened yet.
That can work.
The risk premium this week suggests investors want more evidence.
Perhaps that is the most important lesson from Britain’s crisis so far.
Political authority and economic credibility are not the same thing.
Liz Truss possesses the first.
Markets cannot remove her from Downing Street.
Parliament and ultimately voters determine that.
But government needs other people to believe its promises about borrowing, inflation and future policy if it wants to finance those policies cheaply.
Trust cannot be legislated.
This is true of democratic institutions generally.
A parliament can pass a law.
It cannot pass a law requiring citizens to believe parliament is competent.
A government can issue debt.
It cannot issue a decree setting the confidence investors must attach to that debt.
A central bank can announce an inflation target.
It cannot force households to believe inflation will return to target.
Institutions operate partly through expectations, and expectations respond to behaviour rather than formal authority alone.
That makes credibility a strange kind of political power.
You possess it only while other people believe you do.
Britain’s government has spent its first month promising to break with economic orthodoxy.
There can be value in challenging orthodoxy.
But if the objective is economic growth, proving independence from conventional thinking is not itself success.
The policy still has to work.
Markets have delivered an extremely uncomfortable first piece of feedback.
The government’s next test is whether it treats that feedback as an enemy to defeat or information to understand.
