Kwasi Kwarteng’s “mini-budget” has put the UK government in a horrible position, even a week after the dust has settled on the chancellor’s policies. Immediate panic has given way to more fundamental questions about the nightmarish choices now faced by UK policymakers.
If the UK sticks with the fiscal stimulus still on the table, including the remaining unfunded tax cuts and a huge subsidy for energy, markets will continue to view it as fiscally irresponsible, borrowing costs will rise and the UK’s ability to service its debt may be called into question. If it tries to offset these measures with spending cuts, markets will worry about the implications of austerity on growth and may become concerned about the UK’s ability to finance its borrowing. Absent a complete U-turn in fiscal policy, the Bank of England will be stuck holding the bag for restoring policy credibility and navigating a path between fighting inflation and pushing the economy into recession. There are no good policy choices in the UK. The only question is how the pain will be distributed.
To recap: in providing the biggest tax giveaways since 1972 (with particularly large tax cuts for the rich) and proposing a raft of deregulatory actions, the mini-budget was an effort to drive potential growth up to 2.5 per cent, well above the average over the past 15 years. In many ways, this is a very old-fashioned right-wing agenda, but there is scant evidence of trickle-down economics ever having worked (and a lot of evidence it hasn’t), and the UK is already a low-regulation economy.
Investors voted with their feet. Sterling fell to its lowest level against the dollar, five-year government bond yields saw the sharpest spike on record and equity prices cratered (the opposite of what one would expect when the currency weakens). As anyone paying any attention to the markets last week knows, the sharp rise in borrowing costs created severe market dislocations among pension funds, which were forced to sell bonds, pushing bond prices down further (and yields up higher, as prices and yields move in opposite directions), causing those funds to sell even more government bonds. The only way to break the doom loop was for the Bank of England to intervene and not only delay its plan to start shrinking its balance sheet, but to buy government bonds and expand the balance sheet again. Hence the headlines about a £65bn financial intervention from the Bank late last week.
I’m afraid this is a harbinger of things to come unless the government plan gets a serious rethink. Kwarteng’s mini-U-turn on his mini-budget, abandoning plans to scrap the top 45 per cent rate of income tax, has important distributional consequences (slashing taxes for the wealthy would have exacerbated inequality), but otherwise is relatively macroeconomically insignificant. Given the rich have a lower marginal propensity to consume, it was unlikely boost growth much or to drive up inflation.
The government will release a medium-term budget soon (originally scheduled for 23rd November but it may be brought forward) to show it has a responsible plan to fund the raft of borrowing it just announced—now even more expensive given the jump in borrowing costs caused by the chancellor’s proposed policies. But this will have to involve spending cuts. And if people know stimulus measures will be reversed or offset soon, they are unlikely to change their behaviour now, rendering the stimulus ineffective. It will be politically difficult for this new government to begin pushing through austerity going into the 2024 election as well.
Most likely that leaves the Bank of England as the only game in town once again. Weaker sterling means the UK is importing inflation from abroad. Stimulus measures will add to these pressures, likely raising inflation expectations and risk premiums. To tamp down inflation and control those expectations, the BoE could hike rates in line with what the market expects, ultimately to around 6 per cent. That would push up market rates and, in theory, stabilise sterling.
But such aggressive rate hikes would be costly. They could push the UK into a deep recession and spark not only a mortgage crisis but raise the risk of problems for British banks. Two- and five-year fixed rate mortgages have seen rates soar already, and they will rise further with aggressive rate hikes by the BoE. Mortgage defaults and arrears would increase as house values plummeted, putting pressure on bank balance sheets.
The central bank will be stuck between a rock and a hard place. It can either allow high inflation and a weaker currency to erode standards of living and fuel an even worse cost-of-living crisis, or it can risk sparking a mortgage crisis with a significant human toll. The Bank will no doubt aim to navigate between the two, but with only blunt tools this will be nearly impossible to pull off. The UK may have been headed into recession anyway, with the effects of Brexit really asserting themselves (lower potential growth among them), high fiscal and current account deficits, significant external financing needs and relatively few foreign reserves with which to defend the currency. But the new government’s plan all but ensures it will be longer and deeper.
The mini-budget has sparked dramatic moves in UK bond and currency markets, but the impact outside of the UK has been relatively muted—so far. The concern is what future meltdowns like that of the UK pension fund sector are lurking in other economies. With a globally synchronised interest rate-hiking cycle under way after years of cheap money, new market dislocations are certain to emerge. The only question is how easily they can be foreseen and how systemic they will be.
