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Kwasi Kwarteng’s growth hopes hit by borrowing costs

Economists are rarely united, but the vast majority agreed on Friday that Kwasi Kwarteng’s statement was built on borrowing and hope that things turn out for the best. They expected the new chancellor to be confounded.

Ditching the Conservatives’ carefully crafted reputation for prudence with the public finances, the new chancellor sought to borrow to cut taxes, increase growth rates and improve the underlying performance of the UK economy.

In what he termed “a new era” that “prioritises growth”, Kwarteng promised the additional borrowing would “release the enormous potential of this country”.

Economists were in no doubt about the importance of the statement, noting that the permanent cuts in taxes were the largest in a Budget since Anthony Barber’s in 1972. Torsten Bell, director of the Resolution Foundation think-tank, described himself as “awed” that Kwarteng was “totally rejecting not just Treasury orthodoxy, but Boris Johnson too”.

But most worried that additional growth might be temporary and inflationary, and lead to unsustainable public finances.

There is no doubt about the scale of additional borrowing required. Following the statement, the government’s Debt Management Office immediately set out new plans to borrow an additional £72bn before next April, raising the financing remit in 2022-23 to £234bn.

This borrowing will cover the energy price guarantee for both households and businesses this winter alongside the additional cost of government debt, which rose sharply on Wednesday.

The permanent tax cuts, most of which will come in next April, will need additional financing, which the Institute for Fiscal Studies estimated would result in public borrowing remaining over £110bn in 2026-27, after the energy support scheme comes to an end.

In these circumstances, public debt would keep rising as a share of national income, despite Kwarteng’s pledge that “in due course” he would show it coming down.

Other economists thought borrowing would be even higher. Ben Nabarro at Citi, said he thought borrowing would still be above £150bn in 2025-26.

The chancellor was taking many gambles, economists said. He hoped that borrowing to allow the UK to buy gas at inflated prices had little effect other than to reduce the risk of recession.

Kwarteng maintains that the fiscal stimulus will not increase inflationary pressure at a time of full employment. He is putting its faith that tax cuts would boost the supply side of the UK economy and will raise the underlying rate of growth to 2.5 per cent a year.

The chancellor was also hoping the additional borrowing, which will significantly worsen the UK’s record trade deficit, would not pull the rug from under sterling.

Kwarteng’s team included an “illustrative” table in the Budget documents showing that if the trend growth rate was raised 1 percentage point a year, after five years tax revenues would be £47bn higher than before. There was no assessment on the likelihood of such positive results from the independent Office for Budget Responsibility.

Column chart of Public sector net borrowing (£bn) showing Public borrowing set to be much higher after Kwarteng's tax cuts

While the City, business groups and many taxpayers cheered the reduction in taxes, academic and business economists were sceptical the chancellor would achieve his ambitions with tax cuts.

Richard Hyde, senior researcher at the Social Market Foundation, said the aim of increasing growth rates was welcome, but “it’s not clear that tax cuts are the best way to deliver it. The evidence of previous cuts in corporation tax is that they don’t reliably lead to increases in business investment.”

Allan Monks, UK economist at JPMorgan, said the bank was raising its growth forecast by 0.4 percentage points for just one year as a result of the additional borrowing and spending, something he said was “a low return from such a costly and potentially risky package”.

Since the 2008-09 financial crisis multiple growth strategies, involving higher and lower taxes, have failed to boost Britain’s underlying rate of productivity growth, which has remained low.

Line chart of Yield on 2-year UK government bond (%) showing UK government borrowing costs surge after Kwarteng’s statement

But the bigger immediate worry in financial markets and the Bank of England was that the enormous amounts of borrowing for spending and tax cuts would provide a sugar rush for growth, creating inflationary pressure, higher interest rates and unsustainable public finances.

Jonathan Haskel, one of the members of the BoE’s Monetary Policy Committee, said on Thursday night that, “the difficulty with the fiscal expansion is we’re doing it in the context of a very tight labour market and difficulties in China, which mean that our supply chains are rather compromised”.

With the BoE already having raised interest rates to 2.25 per cent on Thursday, Haskel’s comments confirmed that policymakers would make borrowing more expensive in the weeks ahead.

The BoE’s concern is that the UK economy simply cannot handle the high-pressure boost to demand without generating inflationary pressure and higher interest rates would be needed to cool things down.

Kwarteng and the Treasury documents made no mention of the possibility that the tax cuts would raise inflationary pressure, however. But financial markets thought of little else on Friday and took fright.

They quickly priced in higher borrowing costs to finance the UK government, companies and households. The cost of government borrowing over two years hit 3.9 per cent shortly after the chancellor finished speaking, up from 0.4 per cent a year ago. Market expectations of BoE interest rates next year rose above 5 per cent.

Sterling fell below $1.10 to the US dollar for the first time since 1985, a fall of over 2 per cent in Friday trading alone.

Most economists said the Budget was therefore highly risky and — due to the higher borrowing costs — unlikely to encourage companies to borrow and invest.

Ruth Gregory, senior UK economist at Capital Economics, said that unless the gamble to boost the underlying growth rate works, “today’s fiscal package just means more inflation, higher interest rates and a higher debt ratio in the future”.


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