U.K. Crisis Escalates as Chancellor Kwasi Kwarteng Fired. What That Means for the U.S.
U.K. Chancellor of the Exchequer Kwasi Kwarteng has been fired over his handling of a recent economic crisis that saw bond markets crash.
He left an International Monetary Fund gathering in Washington earlier than planned and was promptly relieved of his position in a meeting with Prime Minister Liz Truss when he arrived back, making him the second-shortest serving Treasury chief in U.K. history. Truss named former Foreign Secretary Jeremy Hunt as his replacement on Friday.
Kwarteng’s dramatic departure leaves the government in dire straits. He and Truss came to power on the back of promises to cut taxes and shrink the size of the state. After just taking office at the beginning of September, the project has proved deeply unpopular with the public as well as investors, forcing humiliating climbdowns after only a few weeks.
The latest U-turn came Friday shortly after the chancellor’s dismissal when Truss announced the government’s plans to freeze corporation tax would be scrapped.
The pound fell on Friday, slipping about 1% to $1.12. Bonds yields, which were initially lower before the announcement rose, with the yield on the 30-year gilt 26 basis points up at 4.816%. The danger of more market disruption hasn’t gone away.
The Prime Minister’s latest steps “are arguably cosmetic and too late to repair the damage that has already been inflicted on investor confidence in the U.K.,” said Simon Harvey, head of FX Analysis at Monex Europe. “The near-term instability will only further deter foreign investment.”
Kwarteng faced fierce criticism over his execution of Truss’s plans for huge tax cuts, funded by new government borrowing. His Sept. 23 “mini budget” went down like a lead balloon and crashed the bond markets. The surge in yields pushed British pension funds to the brink of going bust.
The Bank of England was able to step in with emergency steps to buy long-dated bonds, but made it very clear that the brunt of support would end on Friday. Governor Andrew Bailey stuck to his promise and didn’t extend the program beyond Oct.14, though the BOE could revisit that if market turmoil returns. Bailey did introduce a new program to allow pension funds to use bonds as collateral for loans that will last longer.
The challenge for Truss is managing to roll back her budget plans without losing too much face. Truss staked her political future on reforms that are meant to unleash the productive capacity of the economy, and now it appears she is retreating at the first resistance.
“Part of our mini budget went further and faster than markets were expecting,” Truss said at a press conference on Friday. But she said she’s still on a mission to deliver a “low tax, high wage, high growth economy.”
Truss did indeed drop her plan to freeze corporation tax, saying it would rise to 25% as previously scheduled before she came into office. That reverses £18 billion ($20.1 billion) of the roughly £45 billion of the tax cuts announced on Sept. 23, which she said is a “down payment” on her medium-term plan.
Without giving any specific figures, she also promised that debt as a percentage of the economy will come down in the long term, and that spending will grow less rapidly than planned.
But that still leaves enormous tax cuts on the table to be funded by selling more government bonds. While yields appear to have stabilized for now, they remain elevated. Any further ructions will put pressure on the BOE to once gain come to the rescue. Chancellor Hunt is scheduled to give an update on the government’s budget plans on Oct. 31.
The turmoil in the U.K. matters in the U.S. For one thing, there’s always a risk of contagion that can emerge in unforeseen ways.
Second, it shows how delicate the financial system can be when interest rates rise. The last time the Federal Reserve started a serious hiking cycle in the mid-2000s, it killed the housing market and ultimately led to the financial crisis.
This round of hikes, in both the U.S. and the U.K., is much more aggressive. The lesson is to prepare for more surprises.