Timothy Ash is an associate fellow in the Russia and Eurasia program at Chatham House and a senior sovereign strategist at Bluebay Asset Management.
For just a minute, imagine a country that has been buffeted for years by political instability. It has seen four prime ministers in just six years and three general elections over the past seven. This country also held a referendum on its relations with its neighbors, and voted to leave its main trading bloc, leading to a collapse in its trade volumes and stalling growth.
While this country calls itself a democracy, its new prime minister was chosen by members of an elite club comprising just 0.2 percent of the actual electorate. And now, this prime minister — who hasn’t even won a popular mandate to rule — has launched a populist pro-growth agenda: Taxes on the top 5 percent are to be cut in hopes of kick-starting growth and creating a trickle-down feel-good factor.
Welcome to today’s Britain, a mature G7 country, where it all sounds very emerging market.
The United Kingdom’s economy has deep structural problems, and a fundamental lack of competitiveness as reflected in a current account deficit of over 8 percent of GDP. Years of underinvestment in public services, education, housing and transport have left a poorly skilled and regionally immobile labor force struggling to fill the gaps left by the departure of foreign workers, which was caused by the ruling party’s nationalist agenda.
Similarly, years of underinvestment in the energy infrastructure has left the economy dependent on energy imports and, with little storage capacity, dependent on the vagaries of global spot prices. Inflation is rising, living standards are falling and workers are striking for higher wages. A wage-price spiral looms.
The U.K. government has met these challenges with bailouts and now tax cuts, which will further boost already bloated budget and current account deficits, and increase public debt. Experienced public servants, who might have critiqued such economic policy, have been forced out, and an office for fiscal responsibility has been told to delay publishing updated economic forecasts, for fear it might show government plans in an unfavorable light.
Meanwhile, the “independent” central bank governor has been undermined by constant carping and whispers as to his competency from within the ruling party.
Predictably, the market has been unconvinced by the new government’s dash-for-growth economic policy. Borrowing costs for the government have risen, making its macro forecasts now appear unsustainable. Everything is unraveling, and talk of crisis is in the air.
All of the above sounds like a classic emerging market (EM) crisis country. And as an EM economist for 35 years, if you presented me with the above fundamentals, the last thing I would now recommend is a program of unfunded tax cuts.
Sri Lanka tried to do just that between 2019 and 2022, and it ended up in currency collapse and default.
To begin with, there’s little evidence to suggest that a package of hugely regressive tax cuts can succeed in kick starting growth.
Moreover, with the starting point being a public-sector-debt to GDP ratio of close to 100 percent, the obvious question is, how will all this be financed?
The markets will need to be convinced that the program will, indeed, deliver real GDP growth, and achieve competitiveness gains to address the big account deficit. The markets will also surely ask what the U.K.’s fundamental structural problems are — is it high taxation and restrictions on bankers’ bonuses? Or do the problems run much deeper?
I would argue that the U.K.’s problems start with Brexit, itself the result of years of underinvestment in education, housing and transport, which sparked a huge north-south divide and helped fuel racism, which powered the Brexit vote.
Brexit signaled that foreigners were not welcome in the U.K., and as a result, many skilled foreign workers have now left. But low taxation won’t attract international business back if the country isn’t perceived as open to international labor — which it isn’t.
And even if tax cuts could deliver growth, confidence in the U.K. is now so low that international capital markets have little trust in the ability of British policymakers to deliver.
Instead, in reality, tax cuts likely mean a bigger current account deficit in the short term, which will require either a weaker currency or higher interest rates, or both, to narrow the external financing gap. Interest rate hikes will likely cripple the housing market and force a deep recession, running counter to the government’s pro-growth agenda.
As in many EMs, in the U.K., the “independent” central bank is now being pressured by the ruling party to hold pat on rates, which only risks a currency collapse, fears of a sovereign debt crisis and, ultimately, a banking crisis.
In the EM world, all of this would mean that financing gaps would need to be closed by a combination of fiscal or monetary tightening, and/or currency adjustment, perhaps put off for a time by foreign exchange (FX) intervention — but the Bank of England’s FX reserves are limited.
An alternative is to “phone a friend” — namely, the International Monetary Fund (IMF). However, in an EM setting, if a country goes to the IMF, they would also demand policy tightening, throwing out the country’s pro-growth agenda. Yet, fiscal tightening seems to have been ruled out by Chancellor of the Exchequer Kwasi Kwarteng’s desire to go for growth.
The only option the U.K. has without the IMF, however, is for sterling to weaken even more and U.K. borrowing rates to go higher. But the harsh reality is that even this option would surely crimp growth as well.
It’s time to face that the U.K. government’s growth agenda is simply wishful thinking.