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The UK economy: plunging into deeper crisis

Muhammad Mahmood | October 09, 2022 00:00:00

The new Conservative government of Liz Truss unveiled a comprehensive set of tax cuts keeping in line with her campaign undertakings for the prime ministership to cut taxes and champion supply-side economics. During the campaign, Truss modelled herself on Margaret Thatcher who introduced a series of market-friendly neo-liberal economic policy measures after taking office as prime minister in 1979.

Now Truss has delivered her free market agenda. On September 23, chancellor Kwasi Kwarteng introduced a mini-budget and unveiled the biggest package of tax cuts in 50 years, hailing a "new era" for the UK economy. This costly stimulus package was presented as part of a broader effort to boost the underlying growth rate, but came at a time when the UK's inflation rate is running at close to ten per cent and the Bank of England (BoE) is struggling to bring it down. Furthermore, these tax cuts are to be funded by additional borrowings. As a result, some observers described the mini-budget as a "tax-cutting, debt-fuelled plan of growth".

The UK's economic woes in the 1970s led to Thatcher gaining her position as prime minister in 1979. But unlike Truss, she did worry about curbing inflation and shoring up public finances. But Thatcher's neo-liberal economic policy measures led to even more profound economic transformation since the early 1980s with the onset of the neo-liberal market economy.

The socio-economic changes have been so profound since then that the UK economy has become the vanguard of a new global economic system now known as the "rentier economy." It means economic activities are singularly guided to earn unearned income, also known as economic rent. The drive for unearned income has made a deep mark on the country's business culture.

Now the new chancellor has been caught up in international controversy after announcing his sweeping tax cuts, which are heavily slanted towards the rich and are estimated to amount to about two per cent of Gross Domestic Product (GDP). Truss' tax cuts resulted in a plunge in the pound's value, the government bond market took a dive, soaring mortgage rates, some mortgage markets shut and a £65 billion intervention by the BoE to bail out pension funds.

A group of think tanks, such as the Adam Smith Institute and the Institute of Economic Affairs (IEA), closely connected to Liz Truss and her advisers, however, cheered. The mood was particularly buoyant at the Institute of Economic Affairs (IEA), whose director general Mark Littlewood greeted the announcement by claiming: "This isn't a trickle-down budget - it's a boost-up budget".The mini-budget was also broadly welcomed by businesses seen as an opportunity to move on from years of low productivity and poor growth.

As more details of Kwarteng's budget package have started to come to light, the financial market mayhem has deepened. The mini-budget handed out £45 billion in tax cuts to corporations and the super-rich, to be financed by increased government borrowing of £72 billion. Now the driving forces of the crisis have come into clear focus. The mini-budget has now also engendered a political crisis which appears to be even more serious than the economic crisis.

The adverse reaction of the financial markets was not so much about massive handouts for corporations and super-rich but that the mini budget did not make deep enough cuts in social spending, as reflected in increasing government debt to the tune of £72 billion.

The S&P, a credit rating agency, put the UK on a "negative outlook" while maintaining its AA rating. The credit rating agency also implicitly asked for cuts in social spending as the budget deficit, according to the agency, would go up by 2.6 percentage points of GDP, in contrast to their expectation of a decline by a percentage of GDP from 2013.

The Wall Street Journal warned, "Mounting volatility in government bonds markets is intensifying fears on Wall Street that this year's wild swings in the safest assets could destabilise already rocky financial markets".

Cutting taxes at a time of near double-digit inflation and when the BoE and other central banks raise interest rates was always going to mark Britain as an economic outlier. Many independent commentators opined that the budget measures as crackpot economics. The International Monetary Fund (IMF), bailed out the UK in 1976, also expressed its concerns and asked to reconsider the tax cuts, expressing the fear that the proposed tax cuts would exacerbate inequality and lead to fiscal and monetary policy working at "cross-purposes". However, such criticism from the IMF is usually reserved for the leaders of debt-ridden developing countries.

Former US Treasury Secretary Larry Summers told Bloomberg that the UK was behaving a bit like an emerging market turning itself into a submerging market. He added that if the Truss government sticks to its new policy, the pound's value could drop to less than a dollar. This is because currencies of emerging market economies quite often fall even when interest rates go up, as happened to the UK last week. But an emerging market semblance does not fully begin to capture what is happening to the UK economy. Last week Kwarteng was considering introducing offsetting measures to his tax cuts, and they include a cut in investment in the National Health Service (NHS) and infrastructure investments.

The pound slide illustrates how the act of unfunded fiscal largess has shaken the confidence in the Truss government's ability to maintain fiscal sustainability. The crisis of confidence has been brewing for years.

The present economic crisis in the UK is the most apparent manifestation of a mounting crisis in the global financial system, including the United States (US) and the European Union (EU). Rapid rate hikes in the US are used to rein in rising inflation to induce a recession to ensure that inflation expectation remains anchored to forestall increased demands for the rise in wages. The Federal Reserve is also basing its program that higher interest rates will be able to tame inflation, as happened under Fed Chair Paul Volker in the 1980s. But that also led to two recessions to rein in inflation and raise the federal fund rate to as much as 19 per cent.

But the rate rises also strengthen the dollar resulting in rapid falls in other major currencies such as the pound and the euro. The rise of the dollar has led some financial experts to go for an agreement along the lines of the Plaza Accord of 1985 where leading economies agreed on a set of measures to keep the dollar's value down. But the prospect of such an event is virtually nil now. It is because it will not be in the interest of the US to do so. The reality for the US is straightforward; while the dollar's rise is inflationary for the rest of the world, it is disinflationary for the US.

Many market analysts consider Kwarteng's tax cuts as an act of irresponsibility and an economically illiterate decision. Kenneth Rogoff, a professor of economics at Harvard University, said that Britain was rowing against much greater forces in the global economy. He added, "The verdict will certainly be that the government borrowed too much and should have raised taxes on the wealthy more."

The prospect of a further rise in debt by increasing the supply of bonds produced a rapid drop in their prices, sending their yields skyrocketing. The immediate impact was on pension funds, among the largest purchasers of government bonds. Pension funds have been able to meet their liabilities by investing in long-term government bonds of 10 and 30 years duration, known as gilts, confident they can secure an adequate return, but that was until September 23.

But the price of bonds plunged following Kwarteng's mini budget on September 23. So, the value of the collateral fell, and pension funds were faced with margin calls from their lenders, precipitating the crisis. That led to further bond selloffs as funds tried to meet those demands, exacerbating the price plunge. If the situation were allowed to continue, most pension funds would have faced insolvency.

The BoE stepped in on September 28 to stem a market rout involving £65 billion to buy long-dated UK government bonds (gilts) to be doled out in daily injections of £5 billion until October 14. However, citing potential risks to the financial system's stability, the BoE also delayed the start of a program to sell down (quantitative tightening) its £838 billion of government bond holdings, which was due to begin last week. In effect, the BoE went for quantitative easing (QE) when they were getting ready to go for quantitative tightening (QT) to meet the extraordinary financial challenges created by Kwarteng's mini-budget.

But it is not entirely clear who will benefit from the BoE's intervention in the UK bond market, as many market observers point out that the BoE is dealing with a system riven with conflict of interests. Furthermore, the big question now is also what happens when this emergency bail-out ends. Finally, it is to be noted that turbulence in global financial markets is continuing despite the BOE's intervention in the UK bond market.

Last Monday (September, 3) Kwarteng decided to scrap the 45 per cent cut in the top marginal income tax rate paid by those earning £150,000 and above. But reversing the plan to ditch the top marginal tax rate is not of any major significance. It made up less than 5 per cent of Kwarteng's £45 billion package of tax cuts. As a result, he is still left with the remaining £43 billion of tax cuts along with an increased budget deficit of £72 billion and £60 billion-plus support package to offset the recent surge in energy bills.

The initial response was moderate, the pound climbing by a cent against the dollar and bond yields fell back a little. Paul Johnson, the director of the Institute of Fiscal Studies, said "Unless [the Chancellor] also U-turns on some of his other, much larger tax announcements, he will have no option but to consider cuts to public spending to social security, investment projects or public services."

Adam Posen, a former member of the BoE's monetary policy committee (MPC) said, "The government policies are not only outrageously irresponsible, but they do not seem to understand that the BoE has to respond to these policies by raising interest rates a lot." BoE Governor Andrew Bailey already confirmed that

the Bank would "not hesitate increasing interest rates as much as needed."

The BoE has been struggling much of this year to fight surging inflation by raising interest rates. It raised its key interest rate by 50bps to 2.25 per cent during its September 2022 meeting, the 7th consecutive rate hike, pushing borrowing costs to the highest since 2008. Now the BoE is under tremendous pressure to respond to the country's rising budget deficit amounting to 4.5 per cent of GDP. According to Bloomberg Economics, this would lead to the debt/GDP ratio rising to 101 per cent by 2030.

The BoE is now guaranteed to respond to the loose fiscal policy with an even tighter monetary policy. Money market traders were betting on at least a 150 basis point rise in an interest rate at s the BoE's MPC meeting on November 3. It is also expected that the benchmark rate will almost certainly hit 6 per cent next year.

There is a growing sense among media and political commentators and analysts that the extraordinary economic and political crises in the UK can lead to disastrous consequences. It also mirrors the current state of the wider West. Truss's mini-budget is a product of the crude neo-liberal economic ideology that she earnestly believes in turning Britain into "Singapore - on - Thames". The global importance of these events and the ensuing consequences in the form of economic and political disruptions should not be underestimated. There is a growing belief that the current financial crisis in the UK signifies the emergence of an inflexion point in the operation of the global financial system.

Instead of taking full responsibility for her actions, Truss tried to blame Russian President Vladimir Putin and the conflict in Ukraine for the economic crisis. But it also needs to be recognised that the economic crisis in Britain has been brewing for decades, as reflected in decades of wage stagnation, ongoing impoverishment of working and middle classes and ever-widening income inequality. Now to add to that are rising food and fuel prices and the housing affordability crisis. The continuing adherence to the neoliberal ideology will further worsen the situation.

It is evident now that neoliberal economic policies pursued over the last 40 years have failed miserably to address the country's growing economic malaise. Now whom George Monbiot call neoliberal Ultras, having taken over the government, they completely ditched the traditional conservative value of noblesse oblige and overturned the social democratic consensus that prevailed from WWII until the end of the 1970s. Monbiot observed that "the country is ripped apart by this neoliberal experiment".

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