Britain is in a very difficult economic position. The UK economy, like the US economy, appears to be severely overheated, with significant inflation due to high domestic demand. Unlike America, it is also facing the full force of Europe’s energy crisis, driven by the efforts of Russia’s President Vladimir Putin to use a natural gas shutdown to force the West to leave Ukraine.
So many of us expected the UK economy to go through a rough patch in the coming months, if not years. What few foresaw, as far as I know, was a policy zombie apocalypse.
I’ve written extensively over the years about zombie economics—ideas that have failed repeatedly in practice and should be dead, but somehow still scurry around and eat the minds of policymakers. The preeminent zombie of American economic discourse has long been the belief that cutting taxes on the rich will create an economic miracle.
That belief is still there: Even as infrastructure collapsed to the point that the largest city had no running water, Mississippi tried to increase its economic fortune with… a tax cut. But in America, lately, the zombie economy has been overshadowed by zombie notions about electoral fraud, the impact of immigration and so on.
However, Britain does not (yet?) have an equivalent of the MAGA movement. What it does have is Liz Truss, a new prime minister who seems to fervently believe in Thatcher/Reagan-era economic fallacies.
Before I get into the economic plan that has wreaked havoc on UK bond and currency markets, let’s talk about the myths that seem to have inspired her.
The important thing to understand is that there is no serious discussion about the claim that tax cuts for the rich greatly increase economic growth. The truth is that there is no evidence – none – for that statement.
Of course, people on the right, having grown up with the legend of Saint Reagan, believe that his tax cuts have done wonders for the American economy. But the data doesn’t match.
Reagan slashed taxes on high earners. Here are estimates from the Congressional Budget Office of the average federal tax rate paid by the top 1 percent:
Note both the steepness of the Reagan cut and the rise under Clinton, both of which are relevant to the story.
So what happened to economic growth? It is important to distinguish between the long-term trend – which tax cuts should improve – and cyclical fluctuations. Here is real GDP from the early 1970s (when, for some reason, growth around the world slowed) to the end of the Reagan era, measured on a log scale so that a straight line shows steady growth represents:
I’ve also added a red line showing the growth trend over the entire period. What this picture suggests is that underlying growth in the US remained virtually unchanged in the 1970s and 1980s. The economy collapsed during recessions – especially the double-dip recession of 1979-82 – and grew rapidly during recovery, but by the end of Reagan’s reign, it was more or less exactly where you’d expect it to be if you extrapolated the trend from 1973. until 1979.
And let’s extend the picture into the 90s:
Bill Clinton reversed Reagan’s original tax cuts amid many predictions of impending disaster. In fact, the economy grew a little faster than under Reagan, and by the end of the Clinton years it was above the level it would have reached if you had simply extrapolated the 1973-1989 trend.
There are also multiple state-level examples. There was the “experiment” with the Kansas tax cut, which was a failure. There was Jerry Brown’s tax hike in California, which some on the right called “economic suicide” but somehow failed to prevent an economic boom.
Finally, there is evidence from abroad. As Martin Wolf of The TUSEN points out, Britain has been relatively deregulated and low-taxed compared to its European neighbors since Margaret Thatcher. The relative economic position has not changed much.
So there is no reason why anyone who is not a right-wing apparatchik, sealed in a hermetic intellectual bubble, should believe that tax cuts for the rich are the answer to what ails us.
But on Friday, the Truss administration announced plans for major tax cuts, most notably a 5 percentage point cut in the tax rate for top earners and cancellation of a planned tax hike for businesses. It is unusual for these plans to be described as a “fiscal event” rather than a budget, which allowed the government to avoid presenting detailed fiscal or economic projections — projections that would certainly have been either terrible, ridiculous, or both. But despite all the historical evidence to the contrary, officials insisted that their tax cuts would do great things for the British economy.
Obviously I don’t believe their guarantees. More importantly, the financial markets don’t either. Interest rates skyrocketed on the prospect of more government borrowing, while the pound’s currency value plummeted.
Any of these market moves would in itself have been a signal that investors think the Truss government doesn’t know what it is doing. But their combination is especially ominous.
You see, when developed countries have large budget deficits, we normally expect their currencies to get up. That’s because we expect their central banks to raise interest rates to offset the inflationary impact of the budget deficit, and these higher interest rates tend to attract more foreign investment. That’s basically what happened under Reagan, where a mounting budget deficit – driven by tax cuts and increased military spending – led to a very strong dollar:
But right now, UK markets are not behaving like an advanced country. Instead, they behave like those of a developing country, where investors tend to view budget deficits as a sign of irresponsibility and a harbinger of future policy disasters.
Maybe the markets are exaggerating. Britain is not Argentina, and it certainly has the economic, administrative and, I think, the political capacity to turn things around. But the fact that the markets are treating it as if it were Argentina shows how extraordinary a crisis of confidence Liz Truss managed to create within days of moving into No. 10 Downing Street.
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