Fiscal lunacy in the UK presages crises ahead
Many have predicted the economic collapse of the United Kingdom, but few would have guessed it could occur practically overnight.
To fight soaring inflation of 9.9%, on 22 September the Bank of England (BoE) raised interest rates by 0.5%. Yet the next day, completely counterproductively, the government laid out details of an enormous fiscal stimulus comprising tax cuts (overwhelmingly for the most wealthy) worth £45-billion per year, or 2% of GDP, and subsidies for energy bills whose total cost across two years could reach £150-billion, about 6% of GDP.
It is hard to overstate how poorly Chancellor Kwasi Kwarteng’s so-called “minibudget” was received by financial markets. Nothing in the past 35 years – not the UK’s ejection from the Exchange Rate Mechanism, 9/11, the financial crisis, Brexit, Covid or any Bank of England move – compares with the subsequent reaction to this budget.
In the next two days of trading, sterling lost 5% to hit a low at $1.035, before stabilising around $1.07. The fall took the pound to its lowest level since the present system of floating currencies began in 1971. The pound lost similar ground against the euro. Gilts (UK government bonds) were obliterated. From trading at 1.8% as recently as August, the UK government 10-year bond yield has since more than doubled and is now over 4.1%. UK five-year yields are now higher than Italy and Greece. Former US Treasury Secretary Larry Summers quipped that “the UK is now behaving like an emerging market turning itself into a submerging market”.
Sharply weaker sterling will exacerbate inflation, forcing the BoE into more interest rate hikes. Already the market is forecasting an emergency 100bps hike this month. As the credit outlook deteriorates and the government is forced to borrow more to fund the deficit, interest rates will rise even higher.
This week the BoE is also starting the process of quantitative tightening, or selling bonds worth £40-billion a month, further increasing the supply and putting upward pressure on yields. There are simply too many bonds for sale and too few buyers. It remains to be seen at which price demand and supply will stabilise.
The timing could not be worse. Soaring mortgage rates will lead to weaker growth, making a recession increasingly likely and severe.
Countries like Japan or Italy could manage this dilemma, with positive net-creditor asset positions and current-account surpluses. But like emerging markets, the UK is reliant on foreign inflows. The country runs one of the largest current-account deficits in the world (a measure of the country’s net income from trade and overseas investment), and an already sizeable budget deficit. This is set to get larger after last week’s budgetary announcement.
The twin deficit (budget and current) currently sits at more than £250-billion – a huge amount of capital that needs to be found every year.
Furthermore, post-Brexit investors cannot look to the implicit comfort of the Stability and Growth Pact, European Commission or European Stability Mechanism.
The much-vaunted monetary flexibility of being outside the euro has been replaced by having no credible fiscal or monetary backstop.
The crisis risks engulfing the political coherence of the UK as a whole. The leaders of Scotland and Wales slammed the budget, and Nicola Sturgeon called it “moral bankruptcy”, and said the changes “embed unfairness across the UK. They’re giving tax cuts to the rich, bonuses to bankers and protecting the eye-watering profits of energy companies.” A severe recession will only further calls for Scottish independence.
The UK is now an archetype of exactly how not to run an economy. UBS economist Paul Donovan has compared the Tories’ economic policies to a doomsday cult. South Africa should be grateful to have such a steady pair of hands in Enoch Godongwana, and not a reckless cowboy like Kwasi Kwarteng.
From being a paragon of prudent fiscal management, the UK has managed to trash centuries of credibility overnight. Now, it will be up to the government and BoE to move extremely quickly and decisively to ensure the country does not experience a full-blown sterling and debt crisis of the sort not seen since the 1970s.
Former US Treasury Secretary Larry Summers quipped that ‘the UK is now behaving like an emerging market turning itself into a submerging
market’