james197_ Rob PinneyGetty Images_truss resignation Rob Pinney/Getty Images

What Really Brought Down Truss?

Liz Truss’s swift fall from power appears to have resulted from a clash between what economists call fiscal dominance (the government’s spending promises) and monetary dominance (the central bank’s price-stability mandate). But thinking about what happened to Truss in these terms misses an important and surprising part of the story.

PRINCETON – The resignation of Liz Truss, the United Kingdom’s shortest-serving prime minister, completes a powerful case study of how not to make fiscal policy. But the lesson goes deeper than the idea that British politics was torn apart by a traumatic struggle pitting the government and the Treasury against the Bank of England. The real failure was overlooking major risks built long ago into the plumbing of the financial system.

The fiscal-policy lesson is powerful because it is so easily personalized. Truss will go into history books alongside Lady Jane Grey, the nine-day queen who died (by execution) in the religious turmoil of sixteenth-century England. In fact, the modern UK is facing the equivalent of a sectarian clash of its own.

The mistake – on the face of it – was the government’s announcement of a £45 billion ($50 billion) unfunded tax reduction, amounting to 2% of GDP, which included a small cut in the basic rate and the removal of the higher income band. The originators of the scheme believed, probably erroneously, that it would stimulate initiative, investment, and thus growth. There was also a more expensive package to subsidize energy consumers, at the time the most generous such program in Europe, amounting to some £200 billion, or 9% of GDP.

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