Troubles in the UK economy continue, with the pound tumbling and markets in a tizzy. On Sunday, British Prime Minister Liz Truss signalled she would double down on her economic plan, whose unveiling on September 23 caused much of the turmoil.
Udit Misra speaks to Adam Tooze, Professor of History, University of Columbia, on the market mayhem and more.
First of all, if you could tell us what exactly has led to the current financial crisis in the UK? The mini budget was presented and all of a sudden, UK’s currency, bond yields, everything went in a tizzy.
I think the backdrop is deeper. It goes back to the Brexit decision in 2016. So there was a referendum in which a narrow majority of the population led by the right wing of the Tory party opted to exit the EU. And this was a decision taken in the face of every single serious economic opinion in the world, the IMF, the European leaders, the vast majority of economists in Britain, bankers, the American president — everyone.
And in a sense ever since that moment, we’ve been waiting for the shoe to drop. We’ve been waiting for markets to punish an irresponsible, nationalist, sort of a wilful (government). It’s not fair to say that they are populist. The current crop of Tories are not populist in the simple sense of the word. They’re actually pro-business in their own minds. They believe they’re on a crusade to rid Britain of regulation and lower taxes so as to increase incentives, but they are disregarding market sensibility. And what the markets are worried about is the fact that they have in very short succession passed a gigantic energy price stabilisation bill.
So the other immediate factor operating here is that Europe as a result of Russia’s war on Ukraine and tensions in global gas markets worldwide, which were already manifest in 2021, is suffering an epic energy crisis. At times, gas prices have been the equivalent of a thousand dollars a barrel of oil.
So, really extraordinary prices, and the government passed a package almost immediately on taking office a couple of weeks ago. (The package is) Valued at 150 billion pounds, that’s about 5% of GDP. Then they announced a budget, and in the budget, announced further 45 billion pounds of tax cuts in the form of just giveaways — not investment, not targeted. Just literally giveaways to overwhelmingly the most affluent British people. Somewhat surprisingly — given that the markets are full of the people who benefit from the tax cut — the markets freaked out. Because all of a sudden they sense that this government just didn’t know any boundaries.
Now, defenders of the government will say they expect the Bank of England to jack the interest rate up and that’s part of the plan and then in due course, in a couple of weeks’ time in November, the government will present a programme to slash spending so as to bring the government (budget) into balance.
All the markets are basically signalling is they don’t like this programme; it doesn’t make sense to them. The spending doesn’t seem well-targeted. There’s no reason to believe it will deliver more rapid growth.
This is sort of supply-side idea that you slash taxes and in due course you’ll produce so much growth that the tax revenue will go back up again. The whole thing has a kind of 1980s Reagan-type feel. And that includes the fact that you, as it were, shelter an open, expansive fiscal policy with a tight monetary policy because that’s what America did in the 1980s.
So that was their idea but they did not get their ducks in a row there. They do not communicate this to the markets and the markets don’t buy it because it really doesn’t add up as a programme. It will not accelerate British growth. So what you’re basically saying is you’re going to add very substantially to the debt burden without accelerating growth.
Even in a calm market, you therefore expect interest rates to go up for things to stabilise. What actually began to unfold was something much more panicky — which is that people try to get out of all UK assets. So the exchange rate started going down, which is normally something you see in advanced economies, but it’s a sudden storm, Emerging Market type spiral. So that got people freaked out.
And then there are a bunch of really technical factors operating in the UK treasury (gilt) market.
The famous British government debt market goes all the way back to the 17th century, in which pension funds are very heavily invested in long-run government debt because that’s the kind of debt you need if you’re going to pay pensions 20 or 30 years from now. And rising interest rates are good for pension investors in general because it’s going to help them with their long-run strategies.
But a lot of these pension funds had hedged against the prospect of rising interest rates to give them cover against any particular type of interest movement. And the sudden adjustment in interest rates in and of itself was enough to unwind those hedging strategies and force the pension funds to cover; they were then asked for more collateral on these deals and then they had to start selling and what they sold off was what they thought of as the most stable kind of asset, which is the gilt.
And that began to then produce a really toxic spiral because when people start selling in this panicky way, you get fire sale spreading across the entire market. So much so that early this week, the Bank of England decided that (UK’s) financial stability was at risk. This basically means the house of cards that is the financial system began to disintegrate. Any financial system is always a fragile pyramid. We can build it very, very high but it rests on confidence and a series of interlocking expectations, and those began to disintegrate. And so that’s why we’re in the situation that we’re in.
Recently India overtook the UK as the fifth-largest economy. But data also shows that between 2007 (Global Financial Crisis) and now, UK GDP has stagnated. What is causing that?
The problems of the UK economy are grievous. And they are historic — like never before in modern British history have we had a period of such low growth and such low productivity growth.
I think there are a variety of different factors at play. One is that the financial sector was a huge part of the British economy during the relatively rapid growth phase of the 1990s and the early 2000s and the 2008 financial crisis hit the city of London incredibly hard, knocking out that growth driver.
Beyond that there is then a chronic problem of underinvestment. So Britain has one of the lowest shares of investment in GDP of any of the rich economies of the world — around 15-16 per cent. It’s far too low to generate really rapid growth.
And then the third element is Brexit, which compounds that problem. It will generate inefficiencies which will cost GDP, and provides very little incentive for investment. You add all of those three things up. You add in some other persistent problems — inequality and inadequate training, for instance, and a reduction in the flow of migrants into the British economy, which were dynamizing in British growth in the 90s and the 2000s —and it’s a pretty dismal picture all around.
Globally, driven by the supply bottlenecks in the wake of the war in Ukraine, there’s been a lot of talk about either a recession or a broader stagflation. Which is a bigger concern?
I think there are three possibilities: crisis, recession and stagflation. And we might see all three in differing variance depending on which part of the world you’re in mostly. Sri Lanka has already experienced an existential crisis. Or Pakistan. So as interest rates go up, which is the overall global driver of the recessionary pressure, the weakest links in the global credit chain will snap.
And the more defended you are, the larger your foreign currency reserves, the less your debt is in dollars, the more resilient you will be in the face of this. Because we are currently seeing historically the most-widely dispersed, most comprehensive increase in interest rates we have ever seen in the history of the world economy. It’s not the most rapid increase. That was in the late 70s, early 80s, but practically every central bank in the world, other than Japan and China, is actually raising rates. And that is exercising a squeeze, and those effects are then ramifying. So you get collateral effects from each individual Central Bank, raising their rates.
So the question really is: Do we end up with recession or do we end up with stagflation? The difference would be that with the stagflation we would be saying that we get a slowdown in growth without success in countering inflation. With a recession, you would expect inflation to come down pretty rapidly because the major driver in the end of inflation will be a rise in unemployment and less steam in the economy.
So that I think is the trade-off. In the short run, we’re going to get stagflation. In the short run, what we’re going to see is a dramatic slowdown in growth and we’re going to see inflation almost everywhere around the world above 5 per cent, which is well above the average in recent decades. And so that would qualify for stagflation. When the Chinese economy slows down to 2-3 per cent and the overall growth rate of the world is down in the two, three, four per cent range and we’ve got inflation above 5 per cent, that will be our modern definition of stagflation.
I think there is a risk of recession because the interest rate pressure that’s being applied is increasingly steep, it’s rising now quite rapidly. And that’s in part because prices are proving recalcitrant and not slowing down as much as rapidly as many of us hoped. I still believe that this will be a transitory inflationary burst.