Truss’s Successor to Inherit Grim UK Economy

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No matter who replaces Liz Truss, Britain’s next prime minister will inherit an economy doomed for the immediate future by rising borrowing costs, crippling energy bills, high taxes and no strategy to revive growth.

The race is already on to succeed Truss, who is leaving Downing Street after her attempt to achieve “growth, growth, growth” through unfunded tax cuts for the wealthy backfired spectacularly.

But like her, the incoming Prime Minister will find it difficult to come up with a plan to pull the UK out of the recession it may already be in or its longer-term borders, no matter what is said on the campaign trail.

Inflation is in double digits for the first time in four decades and is expected to rise further this winter, forcing the Bank of England to hike interest rates further. Even after Truss’s stimulus is reversed by the biggest tax hike since 1993, the Treasury will still be grappling with a burgeoning budget deficit, and investors are clearly favoring caution.

“It’s very difficult to see that the current Conservative Party is capable of frankly making a difference in terms of political change,” said Jonathan Portes, professor of economics and public policy at King’s College London. “In terms of taxes and spending, all they can do is try to avoid another explosion in the government’s credibility. You have to play it safe.”

Truss took office just over a month ago and vowed to revitalize the economy with deep tax cuts that seemed to ignore rapid inflation and came to their cover with no immediate plan. The ensuing market panic forced them to turn around, with the tax burden now back at its highest since World War II.

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Most forecasters are expecting a protracted downturn, exacerbated by a switch by the Treasury from focusing on growth to how it will plug the remaining hole in public finances of around £25bn.

What Bloomberg Economics Says…

“Whoever takes over Truss will still be under pressure to balance the books. On the positive side, the gap is smaller than it looked a few days ago. On the other hand, cutting public spending or raising taxes is always painful and controversial. The next Prime Minister will try to deliver them without a direct electoral mandate, a Conservative Party in turmoil and markets ready to punish any misstep – no easy task.”

– Jamie Rush, Bloomberg Economics.

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Households are grappling with increasing pressure on the cost of living, contributing to the government’s declining popularity. The cost of goods and services is rising faster than wages, leaving workers with less money to spend.

Bloomberg Economics is forecasting a 0.4% fall in output next year and says the risks to that are on the downside. Most economists do not expect any significant growth until the second half of 2023, i.e. a little more than a year before the end of the next federal election. One glimmer of hope for Truss’s successor is that early austerity will make room for tax cuts ahead of the vote.

“The challenges ahead are getting bigger by the day,” said Shevaun Haviland, Director General of the British Chamber of Commerce. “Two-thirds of companies expect to raise their prices and inflation is the biggest concern. Interest rates are set to rise further in November and April will see energy bills soar again for many. That is not sustainable.”

Beyond the short term, the painful reality is that the factors that have propelled the UK for the last three decades – cheap goods, labour, credit and energy – are all moving in opposite directions.

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The UK economy prospered in the 1990s and early 2000s along with growing trade with the European Union and Asia which reduced the cost of goods and services. This, combined with falling oil and natural gas prices and a free flow of workers from the EU, led to a downward movement in inflation leading up to the pandemic, allowing interest rates to fall to historic lows.

Now all those tailwinds have reversed direction. Trade disputes with the EU and China and global supply chain chaos have pushed up the cost of goods. The war between Russia and Ukraine cut off the flow of natural gas and caused prices to skyrocket.

While unemployment has fallen to its lowest level in 48 years, at least 300,000 workers have retired from the workforce since the pandemic, making businesses more expensive to hire and expand. A million jobs remain unfilled as older people retire in droves and younger people stay in education.

Forced to focus on the belated inflation shock, the BOE has hiked rates to levels not seen since the global financial crisis more than a decade ago. Central bankers led by Governor Andrew Bailey intervened to prop up a truss-stricken gilt market but are now turning back to the inflation fight and are likely to tighten monetary policy again next month. Most economists are expecting the first 75 basis point rate hike since 1989.

Politicians admit the nation will feel poorer.

“Increases in the relative prices of commodities and energy make us worse overall,” BOE Deputy Governor Ben Broadbent said in a speech hours before Truss stepped aside. He provided some relief by noting that it’s not clear that interest rates will have to rise as much as investors expect.

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The longer-term malaise is reflected in the fact that the country’s trend growth rate has fallen to just 1.2% from 2.5% before the financial crisis, according to Bloomberg Economics.

This reflects a number of deep-rooted structural problems the UK has faced since leaving the European Union. Low productivity and a shortage of workers are making it difficult for the economy to bounce back after a setback.

The textbook levers for generating growth – including increased immigration and closer trade ties with Europe – are almost all too toxic for the divided Tory party, whose MPs are unlikely to seek new elections before the January 2025 due date.

The UK is also missing the game-changing factors that helped it emerge from previous slumps.

Margaret Thatcher had North Sea oil to explore and the big bang of deregulation that unleashed the City of London’s financial district. John Major and Tony Blair attracted automakers and investors, including Nissan Motor Co. and BMW AG, while also opening the door to foreign workers.

These tectonic shifts saved Britain from the energy shocks of the 1970s and the collapse of the pound in 1992. But instead of building new industries, Britain has now severed ties with its main trading partner, scaled back ties with China and is unlikely to a trade deal is coming with the US soon.

“The outlook remains precarious,” said Johan Goltermann, senior markets economist at Capital Economics. “Policymakers in the UK are faced with a difficult set of trade-offs.”

–Assisted by Andrew Atkinson.

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