What is Kwasi Kwarteng really up to? One answer: this is a reckless gamble to shrink the state

Markets have delivered a devastating judgment on Kwasi Kwarteng’s tax-cutting mini-budget. The pound has collapsed to historic lows. And investors have sold UK government debt, driving the price of bonds down and the effective interest upwards at a rate not seen since the currency crises of the 1950s. The combination of the two is particularly worrying because it signals what some fear could become a comprehensive loss of confidence in the pound and UK assets.

You might ask how it could be otherwise. How did the government expect the markets to react when it followed a giant energy crisis-fighting package, roughly costed at £150bn, with a further £45bn in tax cuts that primarily benefit the rich? It also delivered this news at a time when inflation is running faster than at any point since the 1970s and flouted the need for vetting by the Office for Budget Responsibility. What did it expect?

Astonishingly, in the bubble of Downing Street, the answer seems to have been applause. Apologists for Liz Truss and Kwarteng insist that they are embarking on a new era of supply-side reform, in which taxes are set with a view to incentivising entrepreneurship and reviving the growth rate. If this contributes to inflationary pressure in the short term, it is the job of the Bank of England to counter that with higher interest rates.

You might wonder why anyone would want government economic policy and the Bank of England to pull in opposite directions. But that kind of division of labour is not unusual. In the wake of the banking crisis of 2008, we saw tight fiscal policy – in the name of austerity – flanked by ultra-loose monetary policy. That combination has not been a success. Growth has been lacklustre and booming financial markets have fed inequality. The basic idea of Trussonomics seems to be to invert the formula. And there would be a point to that if the £45bn were focused on renewable energy, or investment in education or the health service. But tax cuts for the rich are a terrible way to stimulate growth and one could hardly think of a worse time to deliver such giveaways.

As far as the Bank of England is concerned, it comes as a rude awakening. In the 25 years since it was given its independence the bank has been largely successful in controlling inflation, but it faces a surge in prices and a government pushing determinedly in the wrong direction. Though the Truss team has signalled that it wants to put an end to low interest rates, whether it really likes the medicine it is apparently asking for from the Bank remains to be seen.

In any case, the markets don’t buy it. If they had found the Kwarteng vision of economic policy plausible, rather than selling off sterling in response to the mini-budget, they would have bought into sterling on the expectation of profiting from higher interest rates. Instead, investors simply want out of what looks to most analysts like a doomed experiment. To hold sterling assets they are now demanding what some are calling a “moron risk premium”. To hold debts issued by such an incompetent government requires a reward.

There has been some talk that the UK is at risk of being relegated to the class of emerging market borrowers, whose creditworthiness has to continually be demonstrated to foreign investors. So far, at least, that is exaggerated. The UK has borrowed on a large scale from foreign investors, but unlike an emerging market, it has done so in its own currency. Furthermore, claims against the UK are offset by large British holdings of foreign assets. As a result, even a severe devaluation of sterling would not unleash a destabilising spiral of depreciating currency and rising debt burden.

But the Bank of England is under intense pressure, and the feeble statement it issued on Monday won’t change that. Clearly, rates are going to have to rise and rise fast. The monetary policy committee no doubt regrets the decision at its last meeting to raise interest rates by only 0.5 percentage points. But though it is obvious that it must now raise rates, the Bank faces a serious risk. If it does not act, it will look weak and that may unsettle markets. But if it does make an emergency rate increase, and markets take that action as a sign of panic, the selling of sterling may intensify. That truly would put the UK in emerging market territory, where rate increases are seen as a sign of weakness, not strength. Furthermore, once the Bank of England has embarked on this course, it will have little alternative but to keep on hiking until markets calm down.

Far from reviving growth, the effect will be to deliver a body blow to the UK economy. Tens of billions are being pumped into family purses to help with energy bills. Tens of billions more are being dished out in tax cuts. But interest rate increases will squeeze anyone on a flexible rate mortgage or needing to re-finance. How buoyant does the government expect growth to be when millions of homeowners who bought their homes expecting mortgage rates to be about 1% face interest rates of 6% or more?

And that is not even the last of the bad news. Defenders of the government insist that the mini-budget was only the start. Kwarteng promises further tax cuts. But he also promises to bring the deficit under control. How is that to be squared?

The answer is public spending cuts. Among Republicans in the US, the tactic is known as “starving the beast”. Cut taxes and, as public revenues contract, this will create irresistible pressure for spending cuts. The argument is all the more urgent if you can invoke pressure from the financial markets.

Related: The Kwarteng plan puts at risk the very poorest people in the UK – and growth | Mohamed El-Erian

In 2010, when David Cameron’s coalition government embarked on austerity, it invoked a bond market panic to justify its painful cuts. Then, the panic was more imaginary than real. The debt crisis in Greece served as the bogeyman. Now Britain has a bona fide homemade panic on its hands. Yields on UK bonds have now risen above those of the eurozone debt-victims Greece and Italy. The markets trust Britain’s Tory government less than the heirs to post-fascism in Rome.

Did the Truss government unleash this avalanche on purpose? That is hardly what the “moron premium” suggests. But we should certainly expect them to turn the crisis that they have created against the public sector in pursuit of their misbegotten vision of a small-state revolution.

• Adam Tooze is an economic historian at Columbia University and the author of Crashed: How a Decade of Financial Crises Changed the World

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