Will Trussonomics hit or miss?

Gambling on revived growth is risky, but popular amongst Conservatives

Table of Contents

With Liz Truss nearly certain to become Prime Minister of the UK, media attention has naturally shifted towards how policies proposed in her leadership campaign would play out in the economic conditions of the day.

The key elements of economic policy proposed by Truss are reversing the recent increase in national insurance, and cancelling the planned increase in corporation tax. The changes are forecast to reduce tax revenue by around £30bn annually, and are accompanied by murkier proposals to “simplify” taxation, scrap regulations which hinder growth, and raise defence spending to 3% of GDP.

Fiscal and Monetary Policy

High inflation demands a solution. The expansionary fiscal policy outlined here does not seem to present one. But it is widely accepted that responsibility for inflation sits primarily with the Bank of England via monetary policy. So far the central bank has avoided aggressive tightening of policy, partly in the hope that inflation would blow over, but also in fear of causing unemployment.

Yet tides are changing as statements from Andrew Bailey, the Governor of the BoE, have suggested larger interest rate hikes soon, recognising that some unemployment is less bad than inflation becoming entrenched. Regardless of fiscal policy, we should expect unemployment to bite as inflation falls.

Some economists see potential long-run benefits via creative destruction, which could revive UK productivity and therefore wages and growth. But the extent of this is unclear, and it would still bring unmistakable short-run pain for those who lose jobs, especially given the limited unemployment benefit in the UK.

Fiscal Policy Effects

Trussonomics would push the central bank to raise rates faster, because the policy agenda would stimulate aggregate demand. If we assume the central bank will act to restore inflation to the 2% target regardless of fiscal stance, the obvious outcomes of the proposed fiscal policies would be a larger deficit and higher interest rates.

Higher interest rates would prompt major shifts in the economy. Optimistic thinking might suggest higher interest rates will end up stimulating productivity, despite being initially contractionary. With higher rates, firms are forced to add more value to remain profitable, whereas with the low rates we have seen for a long time weakly productive firms can survive.[1] The extent to which this would actually boost growth is not obvious.

On the other hand, higher interest rates would place excessive pressure on budgets of households with mortgages. These households are often those who can afford it, given the housing market in most of the UK largely rules out home ownership for those on low incomes. But that does not mean no disruption. Many households with mortgages would suffer, and house prices would fall (though a violent crash is unlikely).

The impact of a larger deficit is even more uncertain. Truss is clearly willing to gamble on growth being kickstarted by her policies. If the UK can attain sustained growth levels more like those seen in the US, the increased borrowing would be irrelevant quickly. If growth does not improve, it will look like a waste of £30bn or more at a time when public services are crying out for the money, and could lead to an even worse economic situation.

A Worthwhile Gamble?

So will tax cuts and deregulation create enough growth for this gamble to pay off? Their initial demand effect will not stimulate growth due to the likely monetary policy response, so what Trussonomics depends on is boosting the supply side of the economy. If that works, the payoff will take time.

It makes sense to cut taxes on capital, like corporation tax, seeing as the UK taxes capital at some of the highest rates in the OECD. Improving this incentivises investment, leading to capital deepening and improved productivity, but it is a long process.

Regulation on planning hinders labour mobility, reduce benefits of agglomeration effects, delay and prevent strong infrastructure, and stop people owning homes. Other unnecessary regulation may stunt growth somewhat. Addressing this will have benefits, but they may be cancelled out or worse if useful regulation is caught in the crossfire.

Achieving rapid, sustained growth is a noble aim. If it can be achieved, it would be transformative for the economy, create new wealth to fund public services, and put living standards on a meaningful upwards trajectory for the first time in over 15 years.

At its core, the idea is dependent on productivity gains from creative destruction, higher interest rates, and increased capital investment. If those gains are significant, Trussonomics could change the course of the country. Otherwise, it could be a very costly failure.

  1. https://voxeu.org/article/circular-relationship-between-productivity-growth-and-real-interest-rates ↩︎