Illustration by Priya Mistry

The British economy is headed for a perfect storm

The UK has spent years in hock to a failed economic orthodoxy. Now the consequences are coming to a head—all at the same time
September 8, 2022

The Bank of England’s recent forecast—a 15-month recession, inflation well into double digits and worse, the sharpest fall in living standards on record—was met with shock. It should not have been. Russia’s weaponisation of gas and food prices as part of the war in Ukraine has caused worldwide price hikes and economic woe; these are turbulent times. But in Britain the latest crisis has exposed our extreme vulnerability caused by 40 years of wrongheaded economic policy—which has failed to confront long-running weaknesses and enfeebled those strengths we do possess.

This economic conjuncture is the bleakest I have witnessed in 50 years of observing and commenting on the economy. Every dysfunction—whether it’s poor productivity, our threadbare welfare state, the menace of predatory finance, inadequate human capital, a systemic aversion to risk-taking or a paucity of public investment—has emerged at the same time to create a perfect storm. One could add to these ills a carelessness about who owns our national assets, a lack of economic resilience in critical sectors ranging from energy to water, overheated property prices, exit from the EU’s single market, impotent regulatory agencies, weak business investment—the list goes on.

Worse, the resulting analysis from our political class is desperately inadequate. On the (increasingly dominant) right of the Conservative Party, the answer is seen as doubling down on the Thatcherite brew that is the proximate cause of the crisis: a commitment to small-state economics, low taxes and minimal intervention to “unshackle enterprise” from imagined over-regulation. And the left is yet to offer a systemic, comprehensive response, notwithstanding interventions like the popular proposal for an energy price freeze this winter. Activists demand full-blooded, top-down “socialism” while the broader liberal-left tradition (plainly the direction Labour’s Keir Starmer wants to take his party) fails to work out feasible, practical reforms, leaving a vacuum. In the face of an economic and social emergency, dramatised by millions being unable to pay fuel bills potentially as high as £5,000 next year but with roots that go very much deeper, the political response is not good enough.

The facts are these: inflation, now forecast to peak at over 18 per cent, will only retreat little by little in the years ahead. By 2024 the overall price level will be some 15 per cent higher than was estimated in the autumn of 2021, a forecast already quaintly outdated. The Bank of England is projecting five successive quarters of recession, extending into the last three months of 2023. On both these indicators, Britain’s performance will be the weakest in the G7. The country thus confronts continuing “stagflation”—stagnant growth and ongoing inflation—until at least the mid-2020s, if not beyond. Business investment is running below its dismal long-term average as confidence drops sharply, while hitherto buoyant inward investment from overseas firms has stagnated—both impacted by Brexit. Exports have been savagely hit by the loss of access to EU markets and that loss has not been compensated for by growth elsewhere. In the first quarter of 2022, the UK’s current account deficit (which measures the country’s balance of payments with the rest of the world) was 8.3 per cent of GDP—a scale normally only seen by emergent and basket-case economies.

Sterling has fallen by more than 10 per cent against the dollar since March. Bank of England officials had hoped that interest rates would peak around 3 per cent after the recent rise to 1.75 per cent, but that seems improbable as inflation climbs, simultaneously interacting with the weakness of the currency. The market expectation is that rates will now peak at 4 per cent over the next 12 months, but even that may be an underestimate given the need both to contain inflation and support sterling. As a result, a generalised fall in house prices is increasingly likely: Capital Economics forecasts a decline of 7 per cent over the next two years, with others chiming in with even gloomier predictions. British consumers’ willingness to spend is closely correlated with buoyancy in the housing market: a decline in house prices, although much needed by first-time buyers, will have the unwelcome side effect of adding momentum to the coming recession. Beware: if the incoming administration mishandles economic policy by prioritising inflationary tax cuts, poorly targeted help with energy bills and ill-conceived, unproven deregulation to “unshackle” enterprise, the recession could be much deeper and more protracted than even the Bank’s recent forecast.

The British economy’s vulnerabilities are being cruelly exposed. Where can these vulnerabilities be found and what can be done to remedy them?

Poor productivity, long the bane of the UK economy, has now become acute. Ever since the financial crisis of 2008–2009 the rate of productivity growth has slumped, leaving little scope for wages to grow in real terms. Indeed, after rising by around a third on average for every decade since 1970, over the last 14 years real wages have broadly stagnated—a trend now made starker by prices rising faster even than nominal wages. The 3 per cent drop in the real value of regular pay between April and June this year compared with last was the sharpest on record. The pain is manifesting itself in the wave of industrial unrest this summer and autumn. One in five households is predicted to have exhausted its savings by the end of 2024, and this is happening as the basic level of benefits has dropped to £77 per week—the lowest in relation to average pay on record.

Both the Resolution Foundation think tank and the National Institute for Economic and Social Research warn that the combination of falling living standards and desperately weak income support could push well over a million families into destitution by the next election. The number could rise even higher depending on the scale of support the new government offers households facing dramatic hikes in energy bills. Voices as various as money-saving expert Martin Lewis and Tory mayor of Tees Valley Ben Houchen are right to warn that Conservative leaders have not begun to grasp the avalanche of social distress about to overwhelm so many—with families having to choose between shivering or starving.

Yet the deep-rooted deficiencies of the British economy go unaddressed. Take the skills deficit in the British workforce, which is as immune to successive state efforts to encourage training as ever, exacerbated by weak middle management. Over £3bn of unspent Apprenticeship Levy funds have been returned to the Treasury over the last three years. Colleges, the locus of reskilling and training, report that they are unable to recruit teachers or lecturers at prevailing public sector wages, and so are unable to meet demand for courses in fast-growing industries like robotics or AI. The average number of days an employee spends on training each year fell by 18 per cent between 2011 and 2017.

Public services generally have been weakened by the austerity of the former coalition government, and the tardiness of its successors in loosening the purse strings. Education spending in real terms is projected only to recover to 2010 levels in 2024—and then only if the government is prepared to ratchet nominal spending up in line with the sharp rise in inflation since the 2021 plans were signed off. The NHS, with a record backlog of 6.7m -people waiting for treatment, including for acute and chronic illness, is reeling. People are fearful about the consequences of falling ill as news spreads about waiting lists and the difficulty of even getting an appointment with a GP. From the Passport Office to the criminal justice system, public provision is failing. The decimation of our public realm was not caused by an act of God or even belt-tightening required by underlying economic circumstances. It is an active choice by Conservative politicians who value tax cuts and limited public borrowing over high-quality public services. The results are there for all to see.

Equally worrying is the lack of economic dynamism. The UK stock market now rarely raises new risk money for start-ups, scale-ups or flotations. There is only one fully fledged technology company in the FTSE 100. Enduring weaknesses in investor and bank support for businesses, especially small- and medium-sized businesses, persist. Loans to business are largely still made against the collateral of bricks and mortar rather than ideas, new technologies and business plans.

Nor can we build a dynamic economy while rewards for those at the top remain lush, with incomes at the bottom under such intense pressure. The right believes that inequality and growth go together—as the necessary consequence of offering generous rewards to risk-taking wealth creators—but the UK seems to have the worst of both worlds, with the highest inequality in Europe and growth rates that are truly dismal. Inequality casts a toxic pall over the economy, trapping poorly paid workers in low-growth regions and firms that they cannot afford to leave—with the number daring to switch jobs declining 25 per cent over the last 20 years. The risks are too high: the level of income support if things go wrong is not enough. An important source of dynamism in the labour markets has been closed off.

This helps to explain why international investors now regard the UK as a legacy economy, with very few companies boasting business models based on 21st-century technologies. Instead, our economy is characterised by business behemoths (or small groups of behemoths) that dominate their market sector and so push prices up beyond what they should be—what economists call economic rent. Even the Competition and Markets Authority, charged with preventing anti-competitive practices, observes that ever-higher monopolisation is the rule, corporate mark-ups are elevated and poorer households are suffering most.

As a consumer, you will experience unfair market power in a multitude of ways: direct debits for goods and services at fixed or rising prices that cannot be cancelled until the contract ends; extraordinary charges by professional advisers for essential advice; interest rates for savers that do not rise as fast as rates charged to borrowers, and so on. From the great digital platforms to the utilities, the practice is the same. It guarantees profits but locks out new entrants and limits any incentive to innovate or invest. Many culpable firms are foreign-owned and view the UK as little more than a useful cash cow.

Given all this, it should be no surprise that the sharp fall in the pound has provoked little export response: there just aren’t sufficient companies to exploit the trading opportunities typically offered by a weaker currency. Of course, in a £2.3 trillion economy there are corners of excellence—pharmaceuticals, aerospace, financial and business services, parts of the creative industries, beverages like Scotch whisky. Around our leading universities there is a boom in tech-driven start-ups. Needy of an infrastructure that supports the growth of small businesses, but with leaderships typically progressive and forward-looking in their outlook, these firms do not conform to any conservative image of entrepreneurship.  These firms represent an enterprise revolution waiting to be unleashed—but the opportunity is not being seized. In the City, companies like Legal & General and NatWest, revitalised by a new sense of social purpose, are re-inventing themselves, investing in British enterprise in a way that would have been unthinkable a generation ago.

In terms of state action there are plans for significant—if belated—public investment in infrastructure. There are shards of light showing the way to what we might do better. But how to scale it all up to get there? And how to manage the risks in the meantime?

Here the overriding problem is a Conservative Party dominated by the Brexit right and fixated with policies that have a track record of not moving the economic dial, ranging from an obsession with tax cuts to “free-market” solutions involving hostility to regulations in principle, whatever their economic value. There is no prospect of developing halfway decent public policy without an honest analysis of the situation to be managed, along with a rational relationship with economic reality. For the Conservative Party of 2022 that appears to be impossible.

In this respect, Brexit has been ruinous, not just economically but in its impact on the Conservative Party’s capacity to recognise truth—which now sees any criticism of Brexit as thinly veiled Remainer sabotage. Adverse news cannot, a priori, be true. The British public conversation over this crucial issue is framed by the government’s ongoing denial of reality, which spills over across the gamut of policy. Faith, not rationality, rules.

Thus the Brexit faithful cannot accept that sterling’s weakness, a cause of inflation, might in any way be linked to Brexit weakening investor sentiment. Nor can they recognise that the weakness in Britain’s trade performance might be caused in part by our having erected new barriers with our largest export partner. It simply cannot be true, they argue, that Brexit has created external constraints on policy that our former EU membership averted. The new trade deals that Britain has signed are the future, and compensate for the loss of full access to the EU market. Notwithstanding that Brexit is done, the EU remains a sinister bogeyman to be confronted. Brussels may respond to this confrontation with a trade war—but for the Brexit Tories, that is a price worth paying.

Any level-headed attempts to promote sensible co-operation are stillborn. For example, the UK chemical industry is united in its view that abandoning the EU’s Reach programme of certification for chemical safety is wasteful and economically stupid. We are inexplicably replacing it with a £2bn UK-only scheme, which at best can only shadow the EU programme: by comparison, Reach saw the industry pay only £500m a year for access to the markets of 27 other countries. Be sure that our new prime minister will press on with it, and other self-defeating ideas. Rescuing British membership of the Horizon programme of collaborative, pan-EU scientific research—crucial to any ambition to be a “global science superpower”—will be impossible without a civil relationship with the EU.

How much better it would be if our leaders offered a hard-headed recognition of the external constraints and economic reality. The UK is the second-largest exporter of services in the world—a foundational economic strength. Amazingly, the Brexit treaty is built on zero tariffs for trade in goods—in which the EU is strong—while ignoring British service exports. This is arguably one of the most lopsided and self-harming trade treaties ever signed by a leading economic power. Every muscle should be strained to restore as much access to EU service markets as possible, which means, if not rejoining the single market, then at least negotiating a wide range of sectoral deals to the same end.

The economic risks are raised higher by the obsession with tax cuts as economically and morally good. They reward enterprise and aspiration, goes the free-market mantra, and keep the state’s hands off privately earned rewards—a principle stated repeatedly by Liz Truss in her leadership campaign. That means that, out of necessity, public spending on everything from education to justice is kept on short -rations—the value of taxation in supporting vital public interests consistently underplayed and even flatly denied.

The constraints of economic circumstance demand that the government be savvy in how it exercises its fiscal choices. But there is £30bn—or more—of fiscal headroom available to be spent in 2023 under existing spending plans, and given recession, it would be right to spend it sooner rather than later. The economic and social priority must be to alleviate the cost-of-living crisis and address damaging shortfalls in public and social investment—on health and social care, education, training, research, levelling up, the electricity network and other infrastructure. This will offset recession, build much-needed resilience into key systems and networks, suck in fewer imports and minimise the risk of exacerbating inflation. This is the smart way to boost demand, along with business confidence.

The Tory right has signalled its priority: use the headroom to tax cuts now in the quest for growth. Wrong. Tax cuts loaded towards the rich and corporations—neither of whom need the money—would reinforce the signal to foreign and domestic investors to sell the British market. The reduction in corporation tax from 28 per cent in 2010 to 19 per cent in recent years did nothing to raise investment levels, which remained at the bottom of the G7 league table—as the markets know full well.

Tax cuts may increase demand in the economy but the timing in spring 2023 will only serve to keep inflation pegged higher—raising forecasts for 2023 from 9.5 per cent back into double digits, and making the prospect of a rapid fall in 2024 improbable. A vicious circle would become ever-more likely—protracted high inflation, downward movement of sterling, upward movement of interest rates over and above those already anticipated, a more intense squeeze on living standards, downward movement in house prices, further worries about ongoing recession, further loss of business confidence, and deferral of investment. Stagflation will become even more entrenched—as will inequality. All the baleful phenomena described earlier will remain firmly unaddressed. A sterling crisis is a growing risk.

What is going to relieve this stark picture of wrongheaded policy reinforcing British vulnerabilities and an impending recession? A rise in personal consumption? Unlikely, given the squeeze on living standards and the run-down of savings. An increase in private and foreign direct investment? But in what sectors and for what markets—and why, given the wider economic outlook? A jump in public investment? Hardly, given the prioritisation of tax cuts. An export boom? But to whom, given our reliance on service exports? A virtuous circle built on the green revolution? Implausible, given Tory dismissal of green issues as “woke.” A start-up revolution? Don’t count on it, given the lack of access to EU markets and the absence of a strong system to support fast-growing companies.

The next two years promise to cap the failure of the last 12: a lost decade extending into a lost decade and a half. The situation requires a complete reset of policy—a reversal of almost everything proposed by the Thatcherite tribute acts at the top of the Conservative Party. There must be the marshalling of resources into thought-through national missions. These include levelling up, the drive to net zero, and building key systems that deal with risks to energy security and food supply, as well as pandemics.

The priority of business should be delivering on a social objective from which it seeks to make profit—rather than just profit itself. This should be enshrined in a new Companies Act. In parallel, the regulation, governance and licensing of our privatised utilities needs to be recast so they serve the public interest. We must reinvigorate genuine competition to attack monopolistic behaviour and protect consumers. A scale-up system needs to be put in place to support the maturity of tens of thousands of tech start-ups into tomorrow’s great companies. A huge national effort to upskill our workforce should be launched. If in the 1940s—an era of shortages—a Labour government could launch a system offering vital welfare and social security for all in the wake of the Beveridge report, a recasting of the welfare system in the 2020s is no less vital. The sixth-largest economy in the world cannot tolerate millions of its citizens facing destitution.

And the list goes on. Authoring all this will not be a small state but an agile state, one prepared to take risks and which rewards its servants properly, whether they are nurses, teachers or officials in central government. Active and agile government is not a priori bad; rather it is the core pillar of a good economy and society. It is a vision wholly at odds with the instincts and priorities of this Conservative Party—wrestling with a deep-set crisis that is the consequence of all the decisions its Tory predecessors have taken. It really is time for wholesale change.