Shock and Incredulity: Why Markets Don’t Buy the New British Government’s Growth Plan
Six years after its shock referendum decision to leave the European Union, the United Kingdom has lurched into a new crisis. Following the new chancellor Kwasi Kwarteng’s presentation of the Growth Plan 2022 to Parliament on September 23, three things have happened: yields on UK five-year bonds shot above those paid by heavily indebted Greece and Italy; the pound hit the lowest-ever level against the dollar, spurring already high levels of inflation and undermining the Bank of England’s planned monetary response; and the International Monetary Fund (IMF) issued an unexpected and harsh warning that the package will likely fuel the cost-of-living crisis in the United Kingdom.
How can one explain the steps the new British government has announced? How, for that matter, should the arc of the Conservative Party over the past 12 years—which has swung from the pragmatism and centrism of the Cameron coalition government in 2010 to the ideologically driven posture of the chancellor’s “special fiscal operation” last Friday—be understood?
The Elusive Search for Growth
There are two main answers. The first is nonpartisan. Britain has been struggling to regain dynamic levels of economic growth since the Labour Party came to power in 1997, after the public had last lost its trust in the Conservative Party’s handling of the economy.
In fact, the relative heyday of British economic performance under Gordon Brown’s chancellorship from 1998–2007—when Britain kept its annual GDP growth largely between 2.5 percent and 3 percent, and Germany was derided as the “sick man of Europe”—was a mirage. The financial crash of 2009 revealed that the government had sustained GDP growth through unsustainable levels of credit, while spending generously on public services with tax income from the overexposed banks.
The Cameron government was left to clear up the economic mess. It combined necessary bailouts of the financial sector with what were, with hindsight, overly severe cuts to public services. The then chancellor George Osborne chose the path of austerity to recover Britain’s fiscal position, rather than borrow at historically low interest rates and invest in the country’s future productivity and growth.
Many plans for new cross-country transport links, a “Northern Powerhouse,” green energy infrastructure, worker retraining, and investment in the United Kingdom’s underperforming primary and secondary schools were underfunded. High levels of net immigration from the European Union disguised the underlying weakness of the British economy and supported overall growth, but also opened the path to the EU referendum.
Parts of the Conservative parliamentary party, most notably the new prime minister Liz Truss and the current chancellor, saw the Treasury-led focus on austerity as a missed opportunity. In the 2012 book Britannia Unchained, which they coauthored, they called instead for a radical program of cutting taxes and deregulating the economy. Now, after the sudden fall of Boris Johnson, they have seized the opportunity to put their program to the test.
Demonstrating the Brexit Dividend
But the second part of the answer lies with the “event that must no longer be named”: Brexit. It is not that Brexit has triggered the current crisis. It is that the Conservative Party is trapped by its triumphant rhetoric around the value of “getting Brexit done” and now desperately needs to show some results.
The logical sequence for the Truss government would be to focus first on capping energy costs and providing some tax relief to the most financially strapped citizens. It could also deploy the new microeconomic levers at its disposal, some of which Kwarteng announced on Friday, such as launching new low-regulation investment zones and broader sectoral deregulation. And it could highlight its newfound independence to complete trade deals with India and the Trans-Pacific Partnership grouping. The government would then have waited a decent interval for the economy to start on the path to growth before cutting taxes more broadly, as Margaret Thatcher did in her premiership.
Instead, the Truss government unveiled on Friday what looks like a desperate and reckless dash for growth, funded entirely by borrowing, within just half a parliamentary term. There appears to be no understanding that if the benefits it hopes to draw from Brexit are to materialize, it will take time and a hard, uphill slog.
The core problem for Truss, Kwarteng, and their fellow travelers is that this is not 2012, which is when they published their treatise Britannia Unchained. After Covid-19 lockdowns and bailouts, net public debt stands at 95 percent of GDP, not the 68 percent in 2012 after the rescue of the imploding banking sector.
And, whereas inflation in the United Kingdom was a little over 3 percent in 2012, it is now nearly 10 percent. As a result, the Bank of England is trying to hold back the economy by raising interest rates and unwinding the quantitative easing which had provided ballast to the timid rates of recent UK GDP growth.
In addition, Britain’s current account deficit now stands at a stratospheric 8.3 percent of GDP, double the already high 4 percent during the Cameron government. Brexit is partly to blame, having imposed new frictions to UK trade with the European Union, which remains by far the United Kingdom’s largest trading partner. Then there are the soaring cost of energy imports following Putin’s invasion of Ukraine. The United Kingdom’s current account deficit is exacerbated by the gradual decline in income earned from Britain’s foreign investments.
Furthermore, unlike 2012, the United Kingdom can no longer count on EU support or solidarity through the current energy and economic crisis. In fact, EU members might raise barriers to trade even further if there is no solution to the Northern Irish Protocol, or if the new government’s decision to replace all EU-compliant domestic regulation with new UK laws undermines what is known as the “level playing field” between British and EU companies by the end of 2023.
Nor does Britain stand to benefit much from targeting its cheaper exports to emerging markets. Inflation is depressing growth across the world. And with China still under Covid-19 lockdowns and squarely in Truss’s foreign policy crosshairs, its large consumer market will not be the golden ticket to British export-led growth.
A Counterproductive and Ill-Thought-Out Plan
Given this context, it is remarkable that the chancellor thought world markets would shrug their shoulders at his breezy announcement of one of the most radical tax-cutting budgets since 1972.
If the objective of overturning the former government’s planned corporate and national insurance tax raises and cutting personal income taxes was to underpin growth, then why taunt global investors and the governor in Threadneedle Street by making no effort whatsoever to explain how the additional debt will be managed?
And why refuse to balance the cost of capping personal and business energy prices with the sort of targeted windfall tax on the exceptional profits of energy companies that EU governments on both the political right and left have agreed to, and that many senior British-based energy company executives said they are willing to pay?
The results were predictable. There has been a severe drop in the value of the pound given market concerns over the United Kingdom’s debt sustainability. This will raise prices for consumers and businesses (Britain imports 46 percent of its food and 80 percent of its energy use, for example), eroding its purchasing power and profits, respectively.
Despite the additional depressive effects, the Bank of England will be forced to raise interest rates higher and faster than planned, not just to cap inflation, but now to prop up the pound and keep convincing investors to buy British gilts (public debt). This will put additional stress on British business and mortgage holders. As of Monday, interest rates on two-year, five-year and ten-year gilts had risen tenfold in the last six months to over 4 percent. With over a quarter of the United Kingdom’s £2.4 trillion public debt index-linked to inflation, British debt-servicing costs are soaring. British taxpayers will have to pay this bill, whether through future cuts in services or higher taxes, or, more likely, both.
All this tumult appears to be driven by the government’s determination to prove that Britain can unlock growth following Brexit, but while ignoring current financial realities, and without taking the time to deliver the difficult structural reforms that Conservative and Labour governments alike have avoided for the past 20 years. The more cynical view is that the tax cuts are designed to deliver enough of a sugar high to tempt voters to keep the conservatives in power in 2024.
Either way, it appears those who called Friday’s mini-budget a “special fiscal operation” had it right. Not just because of the subterfuge involved in undertaking a full-scale budget under the guise of a “Growth Plan 2022 speech,” but also because of the government’s inability to foresee its self-destructive consequences.
Robin Niblett is a senior adviser (non-resident) with the Center for Strategic and International Studies in Washington, D.C.
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