Remember, remember Liz Truss this November

Three years on, it seems a good time to reflect on the legacy of that ill-fated experiment. Doing so helps make sense of the fiscal bind Rachel Reeves, the chancellor, finds herself in and her options at what promises to be another momentous budget this November.

Let’s start with the most direct legacy of the mini budget: the policy measures contained therein. For while Jeremy Hunt, installed as fiscal repairman in the aftermath, reversed most of the tax cuts announced by his more hubristic predecessor, he didn’t reverse all of them. Of particular significance was the decision that the health and social care levy, scrapped by Kwarteng at a cost of £15bn to the exchequer, would remain scrapped.

Fast-forward to this autumn. The chancellor is boxed in. To meet her borrowing rules, repeatedly described as “non-negotiable”, it’s widely expected she’ll need to announce either spending cuts or tax rises. The general presumption is that she’ll rely on the latter, given the parliamentary Labour party’s aversion to welfare cuts and the difficulty of unpicking the multi-year departmental settlements set out in the June spending review.

The trouble is, the Labour manifesto promised not to increase national insurance (NI), the basic, higher or additional rates of income tax, or VAT – taxes which, between them, raise about two-thirds of all revenue. Let’s put to one side the fact that the government already increased NI last year, and assume the chancellor would like to raise significant sums this autumn without breaking this promise: no mean feat.

One way to square the circle may be to introduce a new tax, one which functions a lot like income tax or NI, but doesn’t technically breach the letter of the manifesto. It could even be labelled to give voters an idea of where the money is going – a health and social care levy, say? Or, if that’s too on the nose, perhaps a defence and security charge?

Such a move would quite clearly breach the spirit of the manifesto, and add needless complexity to the tax system. The amount raised would bear no relation to the amount actually spent on health, social care, defence, or whatever else it’s notionally earmarked for. But the path of least resistance for a tax-hungry chancellor this autumn could be to further chip away at Kwarteng’s policy legacy, and bring back the health and social care levy in some form.

The mini budget experience had much broader consequences for the UK, of course. Zooming out, there are two key lessons from that episode that the chancellor, her team and – in particular – her backbench MPs might usefully keep in mind over the coming months. First, fiscal policymakers can’t ignore inflation. Second, fiscal rules and institutions do matter, but the bond market is the ultimate constraint on government. Let’s take each in turn.

Any analysis of the events of September 2022 should start with the fact that inflation was in double digits at the time. This is critical. An enormous package of debt-financed tax cuts was expected to drive prices and interest rates higher, for longer. Other actions – the sidelining of the Office for Budget Responsibility (OBR), the ominous hint that there was “more to come”, and the frailties of the gilt market, to name but a few – were also important elements of the mini budget saga. But the decision to disregard the inflationary context was a first order mistake.

Now consider our current predicament. UK inflation is once again stubbornly high. We’re thankfully nowhere near the eye-watering rates we were experiencing in 2022, but inflation isn’t far off 4%, twice the target rate. This is one big reason why short-term interest rates are higher in the UK than elsewhere.

Many have pointed to the policy choices in Reeves’s first budget as having contributed to this state of affairs. The large increase in employer NI contributions, in particular, is often singled out as having pushed up labour costs, which have been passed on to consumers – at least in part – in the form of higher prices. The impacts of simultaneous increases in the minimum wage and employment rights are layered on top.

An additional but less frequently discussed factor is that despite the headline-grabbing tax rises, Reeves’s first budget actually represented a large fiscal loosening. She announced about £40bn of tax rises by the end of the parliament, about £70bn of extra spending, and so about £30bn of extra borrowing each year. The OBR noted at the time that this was one of the largest fiscal loosenings of any fiscal event in recent decades, and predicted it would nudge up inflation.

So, heading into this autumn’s budget, with inflation higher than we’d like, the inflationary impacts of different potential measures and the overall package ought to be part of the conversations in the Treasury and No 10. The chancellor may be especially wary of measures that would show up in consumer prices and directly push up inflation – an increase in VAT, for instance – even if such effects would only be temporary. The timing and context matters.

Which brings me to lesson number two. The fiscal constraints on the UK government are genuine, and they are particularly binding at this moment. We’re in the middle of what Isabel Schnabel of the European Central Bank has described as a “global bond glut”. Lots of governments are simultaneously trying to borrow lots of money, particularly but not only to jack up defence spending.

The UK’s situation is exacerbated by the decline of defined benefit pension funds (traditionally the most important buyers of UK government debt) and the Bank of England’s decision to actively sell some of the bonds it holds back into the market (something which other central banks have decided against), which is contributing to larger projected losses at the Bank of England than elsewhere (see chart). The UK government needs to attract buyers of its bonds from abroad, and is increasingly having to compensate those buyers more generously to do so – hence our rising borrowing costs and debt interest bill. We’re far from alone in this predicament, though our position is more comparable to that of France than it is to that of Germany, which benefits from low starting levels of debt, or the US, which benefits from having the world’s reserve currency.

All that is to say, these are not the ideal conditions in which to be borrowing large sums, and we have no choice but to worry about who will lend us money and on what terms. Contrary to suggestions in some quarters, this is not the result of the fiscal rules or the OBR – though there are legitimate gripes about how our fiscal framework is designed and operated. The key point is that if the fiscal rules were jettisoned tomorrow, and the OBR abolished, the fiscal constraints on the government would remain. If anything, we’d probably find ourselves more constrained: it would hardly convince sceptical bond market investors that this government takes fiscal sustainability seriously, and we could expect to pay a premium on our borrowing, further squeezing the public finances.

The impact of the mini budget on the UK economy is often overstated. It was at least correct in its diagnosis of low economic growth as the UK’s core problem. That event three years ago is not the root of every difficulty the economy now faces. But the experience does provide some valuable lessons as we face up to those challenges this autumn: don’t ignore inflation, and don’t ignore the bond market.

Photograph by Leon Neal/Getty Images