The UK's Economic Experiment Will End In Misery

The drag on consumer demand from rising prices and energy bills is causing public outcry across much of the developed world. Naturally the policy response from governments has been to offer large fiscal packages to sooth the effects of soaring inflation. In the short term, subsidies and price caps will undoubtedly help cash strapped households and businesses navigate a gruelling winter. 

But policymakers should take caution before over priming the fiscal pumps. As interest rates have been rising in the US to tackle inflation, global capital has shifted towards the dollar as a safe haven, strengthening its value and rewarding bondholders with higher yields. The Fed’s tight monetary policies and its winding down of QE programmes means that there is now a growing global shortage of dollars in financial markets. With increased demand and falling supply, the value of the dollar rises higher. Since August this year the dollar has reached a twenty year high against all major currencies. For some weaker countries, a watchful eye on government spending will be needed to preserve their exchange rates and avoid higher inflation. 
 
In the past year alone, the Japanese Yen has suffered a 20% devaluation against the dollar, mounting pressure on the Bank of Japan to raise interest rates and end its decades long QE programmes. Given weak economic growth and relatively lower inflation, the response by Japanese policymakers, however, has been a promise to keep interest rates  close to 0%. 

​Instead, to protect the Dollar/Yen exchange rate from rising further, the Bank of Japan will directly intervene in foreign exchange markets for the first time since 1998. By using dollar reserves to shore up the Yen, the BOJ hopes to cap the dollar exchange rate without having to raise its interest rates. US Hedge funds with sizeable short positions in the Yen will be watching closely. Should the $1/Y145 threshold be breached the BOJ could be forced to fight the markets, which it is unlikely to win. For now, at least, it is a gamble the BOJ is willing to take. 
 
Perhaps the biggest gamble of all, however, is taking place in the UK. The economic response to the cost of living crisis by new prime minister, Liz Truss, of £45 billion is the largest giveaway by any British government in fifty years. In 1972, at a time of similarly high inflation and an energy crisis, the then chancellor, Anthony Barber, introduced a budget that at first led to a temporary uplift in growth but was soon followed by even higher inflation and a currency crisis. Two years after the so-called “Barber Boom”, the UK applied for an IMF bailout.
 
The current UK chancellor, Kwasi Kwarteng, is claiming that his mini budget marks a new era for British economic policy; but the similarities between his budget and the one in 1972 are striking. Given how tax cuts and excessive borrowing measures led to economic calamity in the 1970’s, Kwarteng’s budget might be mistaken for, at best, an act of desperation or worse political point scoring rather than sound economic planning.
 
Since the budget was announced on September 23rd, the Sterling has fallen to its lowest level against the dollar since 1985, reflecting a number of growing headwinds for the UK economy that financial markets now clearly recognise. Among these include Brexit and a widely held view that the UK, given its poor trade relations worldwide, political instability and mounting deficits, now resembles an emerging market economy in Latin America  rather than a fiscally responsible first world nation.
 
While cutting the higher tax band from 45%-40% is aimed at jobs growth and boosting GDP, these measures clearly only favour higher earners. In addition, a reversal of the previous government’s plan to increase corporate taxes to 25%, Liz Truss’s U-turn promises to keep corporate taxes at 19%. Overall, factoring in the various tax cuts and subsidies, the budget dividend for a worker on £20,000 per annum will be just £186, while a worker earning £200,000 per annum will be better off by £2,000. An extreme case would see a worker earning £1,000,000 a year better off by an eye-watering £50,000.
 
Subsidising high worth individuals in the hope that businesses create new jobs may seem intuitive. But these ‘trickle-down’ economic policies have, over the decades, often failed. For one, higher profit margins from lower corporate taxes tend to get re-invested in stock markets and corporate share buyback schemes, not in job creation.
 
Second, studies show that high earners spend far less of their income than the lower or middle classes since their needs have already been met. As consumption makes up roughly 70% of GDP in most modern economies, tax cuts that benefit the rich are unlikely to have any measurable effect on UK economic growth.
 
In his seminal book, “Capital In The Twenty-First Century, French economist Thomas Piketty shows that since the early 1980’s, a decade that defines the trickle-down economic policies of Margaret Thatcher and Ronald Reagan, the return to capital has outpaced the growth rate of output in most of the advanced economies. Due to corporate tax cuts, deregulation of the banking sector and diminishing influence of trade unions, the wealth gap has widened to all time highs.
 
Since the late 1970’s, the effective corporate tax rate has been steadily declining, most noticeable in the US and the UK. Nation states have themselves become pauperised by falling corporate taxes. In the UK the main corporate tax rate has fallen from 52 per cent between 1973 and 1981, to 30 per cent in 2008 and to the current day 19%. Many public services remain under funded and social inequality has been on the rise. The UK is now one of the most unequal societies in the OECD in line with Slovenia and the Czech Republic. According to an article published in the Financial Times last week, the poorest Irish person has a standard of living almost 63% higher than the poorest person in the UK.
 
The pound’s recent fall reflects not just a rising dollar but the harsh realities that now face a desperately divided post-Brexit economy struggling to pay its way and creaking under civil unrest. The current cost of borrowing for the UK government over 5 years is 4.52% and rising. This compares to 1% a year ago. With worsening inflation, a weakening pound, and yet another Tory government refusing to accept its economic realities, the probabilities of a bond crisis in the UK are increasing.
 
In 2012, the ECB’s response to the Euro crisis meant buying massive amounts of government bonds. This drove down long term interest rates on government debt and reassured markets that the central bank would act as a stop gap should any debts turn sour. Bond yields eventually stabilised and the crisis was averted.
 
But the economic environment today is vastly different than the one in which Mario Draghi delivered his famous “whatever it takes” speech. During the great financial crisis, a period when central banks were fighting deflation, US interest rates remained low and the dollar remained relatively weak. Higher interest rates in the US today, however, and a strong US dollar are acting like a wrecking ball against global currencies. This severely limits the central bank's ability in some of the weaker economies to ease monetary conditions when bond yields rise. Today, any divergence in monetary policy away from the Federal Reserve's could badly backfire given weak exchange rates against the dollar. 
 
The Bank of England has no choice, therefore, but to continue tightening financial conditions in the UK. This flies straight in the face of the new government’s borrowing plan however, and illustrates a total mismatch of policy between fiscal and monetary authorities. On the one hand, the government wants to borrow its way out of a crisis, while on the other the central bank wants to raise interest rates. Liz Truss’s appointment as the new prime minister, instead of giving much needed stability to the UK, looks certain to exacerbate deep rooted social and political tensions leading the UK down a path towards greater economic misery. 

Given the UK economy’s structural weaknesses, namely falling tax revenues, rising debt and a potential balance of payments crisis, investing in UK gilts is becoming an increasingly risky trade. Bond yields could rise far higher than the government expects. In the short term, the Bank of England could put a lid on rising yields by increased bond purchasing. The effects, however, could be devastating on the pound leading first to a buyers strike on bonds followed by an ever weakening currency and spiralling inflation.
 
The extent to which the UK is now backing itself into a very tight corner financially, suggests that fiscal restraint and structural reforms are its only credible response should it wish to avoid further punishment from financial markets. Despite the populist free-for-all budget of Liz Truss, the prospects of austerity and harsher budgets in the coming years looks inevitable. Should the hard medicine be ignored the indignity of another IMF bailout, the UK’s second in less than fifty years, may yet be forced upon it. In recent times, going it alone hasn’t served the UK well after all.