A Fine Economic Mess in the United Kingdom

U.S. stocks fell again on Monday, dragging the Dow Jones Industrial Average into bear market territory — now down more than 20 percent since peaking earlier this year. The US Federal Reserve’s determination to stamp out inflation by raising interest rates has spooked investors, as has the sterling’s sharp fall in currency markets. On Monday, a senior Federal Reserve official, Raphael Bostic, took the rare step of criticizing a foreign ally, saying the UK government’s new package of tax cuts that sparked the pound’s sell-off “has really increased uncertainty”.

Think patriotic Brits, if you will. Having just buried Queen Elizabeth II, their last remaining connection at a time when their schoolbook maps showed much of the earth’s surface in imperial red, they now face a humiliating currency crisis. In Asian trading, sterling hit an all-time low of $1.035 against the US dollar early Monday. As trade shifted to Europe, the ailing currency rallied somewhat on speculation that the Bank of England would announce an emergency rate hike to strengthen the pound. The currency’s slide continued on Monday afternoon after the Bank of England didn’t announce a rate hike but said it could do so at its next monetary policy meeting, which will not be held until November.

That statement didn’t wow the global market, which has been dumping British assets since Friday when Liz Truss’ new Conservative government unveiled a sweeping package of tax cuts to be funded by additional borrowing. This costly stimulus package came on top of a previously announced energy price bailout package for households and businesses, which in turn came on top of the necessary but costly efforts made by the previous Boris Johnson government to insulate the UK economy COVID. It also came at a time when Britain’s inflation rate is nearing 10 percent and the Bank of England is struggling to bring it down.

Also Read :  World Green Economy Summit 2022 attracts 12 sponsors

The huge tax cuts are heavily biased towards the wealthy and will amount to nearly 2% of UK GDP. Kwasi Kwarteng, the new Chancellor of the Exchequer, presented them as part of a broader effort to boost the UK economy’s underlying rate of growth. Many independent commentators have condemned it as mad economics. It’s “the biggest package of tax cuts in 50 years without even the semblance of an effort to get public finance figures in order,” said Paul Johnson, director of the bipartisan London-based Institute for Fiscal Studies. The most scathing judgment came from Larry Summers, a former US Treasury Secretary. “I’m very sorry to say this, but I think the UK is behaving a bit like an emerging market turning into a declining market,” says Summers said Bloomberg. If the Truss government sticks to its new policy, the value of the pound could fall to less than a dollar, he added.

I don’t always agree with Summers, but in this case, he’s hard to argue with. One of the characteristics of emerging markets is that investors tend to be skeptical about their public finances and demand additional compensation for holding their sovereign debt. This is what happens with UK bonds. On an average trading day, bond yields can change by two or three hundredths of a percentage point. Since Friday, the UK 10-year bond yield has risen far more sharply, from 3.46 percent to 4.28 percent. “It’s basically the market saying, ‘A, we don’t believe in a trickle-down economy and that growth will miraculously happen,'” said Paul Donovan, chief economist at UBS Global Wealth Management Wall Street Journal. “And B, you see this magic money tree you just planted – we’ll use a chainsaw.”

Also Read :  What Is Deflation? Definition, Examples, Causes & Solutions

Another characteristic of emerging markets is that their currencies sometimes fall even when interest rates are raised. So too in Britain Last week the Bank of England raised interest rates to 2.25 percent for the seventh time in a year, but that hasn’t prevented the pound’s subsequent tumble, which has left the bank, Andrew Bailey, in a bind. Sterling’s fall makes UK imports more expensive and increases inflation. This puts pressure on the Bank of England to raise interest rates to ease inflation: in its statement on Monday it said it “will not hesitate to change interest rates as much as necessary to bring inflation back up.” to bring the 2% target”. At the same time, the Bank of England announced last week that the British economy was already in recession. Further rate hikes would likely make the slump deeper and longer. The British people would suffer.

In other words, thanks to Truss and Kwarteng, Britain is in yet another fine economic mess, which some commentators are even comparing to that of the 1970s, when high inflation and sterling pressures forced Jim Callaghan’s Labor government to resign. Cap in hand, to the International Monetary Fund for a bailout. The country relies on foreign investors’ confidence in British assets to fund its budget and trade deficits. If their willingness to buy UK bonds wanes, the pound’s decline could accelerate further, posing the risk of a major financial crisis – or, more likely, drastic action by the Bank of England.

The tragedy is that all of this is unnecessary. Although Britain has endured many difficulties in recent years, it is the world’s sixth largest economy, has a stable political system and London is one of the world’s largest financial centres. If his government were even remotely competent, the risk of a financial explosion would be minimal. Unfortunately, this basic civic requirement is not met.

Also Read :  India’s robust growth momentum may create macro stability challenges for economy

In the past six years, the Conservative Party has jettisoned its economic skepticism and embraced wishful thinking and self-sabotage. After the 2016 Brexit vote, she joined the claim that leaving the European Union, erecting trade barriers to the UK’s largest market and preventing eager European workers from crossing the English Channel and taking jobs only available to employers hard to fill would help the economy in some way . Now, under Truss and Kwarteng, a new Tory government has adopted a warmed-up version of Reaganomics, claiming that deregulation and tax cuts for the wealthy will boost Britain’s growth rate to 2.5 percent over the medium term. The independent Office for Household Responsibility estimates a much lower rate of 1.75 percent. Such a large increase – almost fifty percent – seems unlikely.

The government did not subject its tax package to the scrutiny of the OBR, which George Osborne, a former Conservative chancellor, set up to ensure some external scrutiny of public finances. Before Kwarteng made his announcement last week, the OBR offered to produce a new economic forecast that includes the proposed tax cuts. The government said no. That was the indication that trussonomics was on the rise – and the financial markets took notice.

On Monday, Kwarteng, who is earning a Ph.D. in economic history from Cambridge, tried to fix things by saying he would present a comprehensive medium-term strategy on November 23, complete with a new forecast from the OBR. But that’s almost two months away, which is an eternity in financial markets. Until then, something can give way. ♦