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 mini-budget 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 of $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.
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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 what 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”, saying 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. DM/BM
This story first appeared in our weekly Daily Maverick 168 newspaper, which is available countrywide for R25.
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I’m afraid it is you who is the fiscal lunatic and your left wing biased economic views are exactly the ‘groupthink’ that Kwasi is trying to rebel against. The UK is permanently stuck in low growth because of high taxation and over zealous regulation, this mini budget would start to address that. The reaction of the markets has far more to do with the BOE losing control of interest rates than a few billion in tax cuts. The 45% rate cut would have paid for itself both in real terms and in growth (see support of Arthur Laffer) and the main spending was on energy support which benefits the poor disproportionately. I could carry on with dissecting your article as it is a Swiss cheese of left wing rubbish. Just to say the pound is now trading at $1.14 and thank god the UK is not in the EU which created half the problems in the first place
Hi Nick, thanks so much for your comment! Appreciate the feedback! Being called “leftwing” is definitely a first. You can call it “groupthink”, but ultimately finance ministers have to live within the ambit of reality, which ultimately is set by economics and markets. Strange to have to point this out to someone defending a budget of the Tory party.
On your points
1) I don’t think you will find that higher taxes or overly burdensome regulation are the source of low UK productivity. I am not allowed to post links here but feel free to tweet me at @NataleLabia and I’d be happy to share
2) On the Laffer Curve; maybe, maybe not. That was not my point. My point is that unfunded tax cuts in a moment of breakneck inflation and rising yields is irresponsible given the obvious market reaction, which has hurt the UK economy and UK borrowers. Thanks to this budget UK mortgage rates are above 6% for the first time since 2008 and the BoE is having to directly intervene to support the gilt market. I fail to see how that can be pro-growth?
Anyway, thanks for reading!
I will tweet you so you can send the links, thanks. If you are not left wing it’s a big surprise you are against tax cuts and deregulation. I also find it funny that for so long economists have said interest rates should be higher and when they start to rise it seems wrong??? The housing market and asset prices need reigning in, it had to happen sooner or later.
The market was reacting more to the £900 billion in quantitative easing that was coming to an end, than the mini budget, hence the £ going back up when the BOE gave it minimum support.
If you look at the overall budget there is a £21 billion tightening in taxation (fiscal drag) so balancing this with support and mild tax cuts absolutely makes sense.
Most economist do not have a great record of predicting growth or disaster (2008?) and I predict they will be wrong about this change of direction for the uk economy, growth is key to having more money to spend on services and redistribution, without it you are left shuffling a smaller and smaller pie.
I would be interested to know which half of the UK’s problems the EU “created”?
Nick, if taxation is too high, then those who can least afford the tax burden should be relieved of it, not the rich who can afford it. But the British government only gave the rich tax cuts, which clearly shows an ideological approach and not one which is really aimed at getting the economy going, irrespective of what they are saying. And the EU did not create the UK economic problems; the problem with EU membership was about immigration and the instability and feeling of “not-being-safe” that it created among existing UK citizens; just keep that in mind. Which is more, as far as I know some EU countries tax the rich far more than the UK, yet their economies prosper. I agree that regulation must be limited, but even with that, regulation is needed when it makes the citizens feel safe.