Truss U-turn is welcome, but it’s only a first step

After days of insisting there’d be no backtracking on a mini-budget that sank the pound and caused panic in financial markets, the UK government has duly reversed itself. Prime Minister Liz Truss and Finance Minister Kwasi Kwarteng confirmed on Monday that the promised cut in the top rate of income tax from 45% to 40% would be canceled. “We get it, and we have listened,” said Kwarteng.
Give the two a particle of credit for choosing not to dig in regardless of the consequences. That wasn’t a given. Truss takes inspiration from Margaret Thatcher, who famously once said, “To those waiting with bated breath for that favorite media catchphrase, the U-turn, I have only one thing to say. ‘You turn if you want to. The lady’s not for turning.’” For Truss, this celebrated line is now an indelible rebuke.
In truth, she had little choice but to pivot. The financial turmoil induced by the budget had her own party threatening rebellion. Parliament looked ready to vote the proposal down, putting her survival in office at risk. For the moment, anyway, the reversal restores some semblance of control. The pound has recovered its recent losses and long-term interest rates have subsided.
On a narrow reading of the fiscal arithmetic, investors’ reaction to the U-turn might seem almost as exaggerated as their initial reaction to the budget. Reversing the cut in the top rate of tax raises relatively little revenue set against the £45 billion ($51 billion) cost of the plan. But what drove the panic was not so much whether the plans were affordable as whether Truss and Kwarteng could be trusted to execute them responsibly. The top-rate cut was recklessly provocative. Indeed, until Monday, every signal from the Tories’ new leader seemed calculated to undermine confidence.
The sudden reversal could give the new government a second chance, so long as Truss offers further assurances that she’ll be prudent. Among other things, this means patching things up with the European Union; taking advice from the Office for Budget Responsibility (the independent fiscal watchdog) on Treasury plans for taxes and spending; and consulting the Bank of England on the interaction of fiscal and monetary policy, while avoiding any suspicion that she’s aiming to override the central bank’s judgments.
That last point is one other governments should ponder as well. Fiscal and monetary policy have to work in harness. The UK is not alone in having to press down on high inflation while also managing the supply-side shocks induced first by the coronavirus and then by Russia’s war on Ukraine. The more fiscal policy is loosened to cushion economies against these pressures, the harder it is for central banks to tighten monetary policy and bring inflation down.
Last week’s debacle in the UK highlighted the problem in the starkest way — by obliging the central bank to buy government bonds (which eases financial conditions) just as it was planning to start selling its own holdings. Other governments can expect to face similar difficulties if they let fiscal and monetary policy move out of alignment. The challenge for Europe is especially acute. Its supply-side disruptions are severe, calling for added fiscal support; yet many of its economies are already carrying high levels of public debt, putting financial stability at risk as long-term interest rates rise.
There are no easy answers. Macroeconomic policy has rarely been as challenging as it is right now. But that’s no excuse for compounding the problem with outright incompetence.

—Bloomberg