Amy Mackinnon and Anusha Rathi
The British pound plunged to a historic low against the U.S. dollar on Monday, as plans announced late last week for a 45 billion pound (about $48.4 billion) tax cut and massive new borrowing to pay for it sent shockwaves through markets and caused a crisis of faith in the ability of the new British government to pull the country’s stalling economy back from the brink of recession.
By Wednesday, the crisis had grown so acute that the Bank of England said it would reverse its previous plan to sell off bonds and would instead start buying bonds to backstop a collapsing market, warning that continued volatility posed a “material risk to U.K. financial stability.” Having stabilized somewhat on Tuesday, the pound again dipped following the news to $1.05.
Britain’s economic crisis this week comes after the largest tax cuts in over 50 years were announced by new Chancellor of the Exchequer Kwasi Kwarteng on Friday and are set to be funded by increased government borrowing. New Prime Minister Liz Truss has defended tax cuts for some of the country’s top earners, arguing that it will ultimately drive economic growth. But skeptical investors rushed to offload the British currency and government debt, briefly driving the pound to $1.03 on Monday, while the appeal of British bonds utterly tanked, rising to the highest borrowing cost in decades, putting pressure on pension funds and other big holders of debt, which threatened a systemic collapse.
The pound’s slump—to be followed by a widely anticipated rise in interest rates—comes as the country is battling the economic aftershocks brought about by Brexit, the COVID-19 pandemic, and Russia’s invasion of Ukraine.
The International Monetary Fund (IMF) offered a sharp critique of the planned tax cuts, which have been widely panned by economists, urging the government to “reevaluate” the measures, warning that they could drive up inflation and inequality.
It is the latest in a series of setbacks for the British economy that have gradually undermined the country’s standing as an economic powerhouse since the country voted to leave the European Union in 2016. As the economic crisis threatens to become a political crisis, here is what this latest setback could mean for Britain and its position in global finance.
What’s the backstory?
In many ways, Britain’s broader economic headwinds are not unlike those currently being felt in the United States and elsewhere in Europe due to the lingering effects of the pandemic and the war in Ukraine: rising inflation, spiraling energy costs, and a tight labor market. But the U.K. has an additional Achilles’s heel—one it caused itself.
“The U.K. economy was already vulnerable because of uncertainty after Brexit,” said David Henig, the director of the U.K. trade policy project at the European Centre for International Political Economy. Foreign investment stalled following the 2016 vote to leave, while trade with the EU—the country’s biggest trading partner—slumped after Britain formally exited the union at the beginning of 2020. Britain went from a member of the world’s biggest trade bloc to an outsider. Last October, the Office for Budget Responsibility (OBR), a public body that provides independent analysis of public finances, forecasted that Brexit would shrink the U.K. economy over the long term by 4 percent—exacting a greater toll than the pandemic.
As Russia’s invasion of Ukraine this February sent energy prices skyrocketing, U.K. households were expected to be squeezed even more than their counterparts in Western Europe due to poor insulation and a high dependence on gas to heat homes, according to an IMF analysis. In response, the U.K. government announced this month that it would step in and subsidize energy bills for households and businesses in what may amount to the biggest government intervention in the economy in decades. The independent Institute for Fiscal Studies estimated that the move would likely cost 100 billion pounds (about $108 billion) over the course of the next year. (For comparison, a government program to keep paying workers furloughed during the pandemic cost nearly 70 billion pounds over the course of 18 months.)
The energy price cap received broad support across the political spectrum and among the British public.
“Any government of any political complexion would have done it,” said Jonathan Portes, a professor of economics at King’s College London who served as chief economist at the U.K. Cabinet Office from 2008 to 2011. “It’s probably not a crazy thing to do. It will help support households over the winter and stop people being even worse off than they already might have been.”
It was Friday’s announcement of wide-ranging tax cuts, in the midst of an already ambitious government spending program, that shook the markets’ faith in the new government and sent the pound nosediving on Monday. Sterling has lost more than 20 percent against the dollar so far this year—and has further to fall, some economists say.
“This juxtaposition of having a sliding currency and rising bond yields is exactly the sort of thing that you see in emerging markets’ sovereign debt crises and are symptomatic of investors losing faith in the country,” said Charles Bean, a professor of economics at the London School of Economics.
What’s driving the government’s decisions?
When U.S. President Ronald Reagan cut taxes amid high inflation in the early 1980s, the dollar surged, benefiting from its position as the global reserve currency and an otherwise robust global economy. While Truss may have gotten her inspiration from the Gipper, the opposite has happened in the U.K., as investors have begun to question the competency of her government. Economists and political commentators worldwide have concluded that the government has a road map but doesn’t know how to drive.
“This is a government which is driven by ideology. It wants to cut taxes but is incoherent and basically doesn’t know what it’s doing,” Portes said. Citibank described the move as a “huge, unfunded gamble for the U.K. economy.”
That has led markets to factor in what some economists call a “moron risk premium” on their investments—the expectation of higher returns for being willing to hold the debts of a blundering government.
As she was campaigning for leadership of the Conservative Party, Truss promised to tear up “Treasury orthodoxy.” Her promises of unfunded tax cuts had already begun to spook the currency and bond markets before Monday’s currency crash. One of her first moves was to remove Tom Scholar, the most senior civil servant at the British Treasury, even as questions linger about the economic experience of those surrounding her. “The cabinet is not that experienced,” Henig said.
Friday’s announced tax cuts were not accompanied by a review by the OBR, which compounded concerns about the policies’ impact. “The government decided it was going to introduce these fiscal measures without any assessment on the state of the public finances, so you’ve got here a bunch of things which are downgrading the institutional framework around policymaking,” said Bean, who previously served on the OBR’s Budget Responsibility Committee.
Kwarteng has since promised that an OBR review of the decision will be made available by late November—but time is, quite literally, money when it comes to financial markets, and much can happen before the next OBR review.
What’s the impact?
In the near term, a fall in the value of the pound will make imports more expensive, further driving up the cost of living and inflation for an island nation that imports about half of its food and fuel as well as other staples. Economists expect the Bank of England to announce a hike in interest rates in response, putting it in the unusual position of trying to pump the brakes while the government tries to rev the engine.
And while economists have compared the U.K. to an emerging market—or, in the words of former U.S. Treasury Secretary Larry Summers, a submerging market—Britain’s status as one of the world’s major economies helps provide it some of the insulation that British homes are lacking. The U.K. has the second-lowest debt-to-GDP ratio in the G-7, and unlike in emerging markets, that debt is denominated in the national currency. An outright debt default is considered highly unlikely, even if British bonds have this week made Greek and Italian debt look gold-plated.
Yet the markets are experiencing cold feet. “This is a huge vote of no confidence from the markets,” said David G. Blanchflower, a professor of economics at Dartmouth College. “And politically, this is a disaster.”
After 10 years of austerity, followed by a pandemic and the war in Ukraine, the British economy, riddled with myriad systemic issues, is stagnating—or dying a death by a thousand cuts.
“The cuts are coming in thicker and faster. They used to go in by day; now they’re coming in by the minute,” Blanchflower added.
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