The Young Fabians Economy and Finance Network give their monthly report on the state of the British economy, in the wake of a disastrous mini-budget, a plummeting pound and unprecedented Bank of England intervention.
In what was a chaotic, disastrous and unprecedented month for the British economy, the not-so-mini budget delivered a package of tax cuts that even would have made Margaret Thatcher, ever the radical neoliberal, think twice. The price paid however, has resulted in an extremely volatile gilt market, a near miss on a full-scale pension and mortgage crisis, a pound close to parity to the dollar and confidence in our markets in the trenches.
Liz Truss and Kwasi Kwarteng seemed to have launched an economic rocket, soaring towards a fantasy galaxy known as ‘trickle-down economics’, only to have found the rocket disintegrate mid-air, and embarrassingly crash back down to earth.
One of the alarms that had gone off indicating that things were wrong, was the plummeting value of the pound against the dollar. On September 23, the day of the ‘mini-budget’, the pound fell to 1.0850 against the dollar, down from 1.1262 the day before. It was clear what international markets thought of the budget. At its lowest, on September 27, the pound reached 1.0726 to the dollar, with real concerns that the value would reach parity, a situation in which 2 currencies can be converted one for one.
To delve into the reasons why this unprecedented drop in the value of our currency happened, we have to look at confidence, at least in an economic context. The colossal set of tax cuts, and reversal of planned tax rises, means that the government would have to greatly increase government borrowing levels to fund them. According to the government, the intention of these tax cuts is to drive economic growth, with the belief that the wealth creators of this country are completely situated in the City and the Docklands, and by incentivising them, the country will get wealthier. This would in turn pay for the tax cuts itself, while growing GDP.
Distinguished economists, and average voters, would all mostly agree that ‘trickle down economies’ have failed before, but importantly, international market investors shared this view too. They began selling off the pound, unconfident that our economy would reach anywhere close to the 2.5% annual growth target set by the chancellor, with concerns that the UK government could default (be unable to repay) on its debts. On the date of the budget, the cost of insuring Britain's debt against a default rose to its highest level since mid-2020, where 5-year credit default swaps (an investment in which the seller will compensate the buyer in the case of a default on a debt issued by the buyer) jumped to 34.5 points, rare for a G7 economy. All of these questions on the future health of our economy in turn weakened the pound, and consequently raised the cost of borrowing, where the yield on 5-year and 10-year government bonds had risen up to 4.7 % and 4.5% respectively, both from around 2.9% 1 month ago. This in turn made the government’s plan for borrowing harder, creating a spiral for the pound to plummet.
The consequences of a weakened pound are severe, not least because oil and gas, commodities which are still inherently linked to our economy, are traded in dollars, raising the price of importing them. All other imports become more expensive as a result of a weak currency (devaluation) seeing as an additional cost is added to the price of all imports. Due to the fact that a large number of goods measured in the Consumer Price Index (CPI), the ‘shopping basket’ of goods used to measure inflation, are imports, this drives inflation upwards.
Inflation, a measure of the rise in price of goods and services over time, stands at 9.9% as of October 1, far from the Bank of England’s (BofE) target of 2%. With the BofE’s prediction that inflation will reach 13% later this year, this spells bad news for the economy. High inflation reduces your purchasing power, meaning you buy less per unit of currency. This can cause harmful economic distortions, such as discouraging savings, and benefits certain types of economic activity over others.
Inflation also becomes baked in if it persists, meaning that, in theory, the long-term impact can cause a broader collapse in the currency and financial system if not addressed. Consequently, the Bank of England is empowered to reduce inflation by increasing the cost of borrowing, which could create a collapse of economic activity across the UK, consumers and businesses lose incentive to buy or sell goods, causing an ever dreaded r-word, recession. The potential butterfly effect of this budget is far reaching.
Throughout this mini crisis, the Bank of England, made independent on the first day of the Labour government in 1997, has stepped in to play a huge role to try and calm markets. One major step they’ve taken over the last week was to use Quantitative Easing to stabilise the rapidly changing price of bonds. Quantitative Easing (QE), used previously in the UK during the Global Financial Crisis of 2008, is where a central bank buys government bonds to keep interest rates down and improve market liquidity. As touched on earlier, given that government bond yields were soaring as a result of the budget, the BofE confirmed it was planning up to £65bn of new quantitative easing. Government bonds are invested into by pension funds, given they are a low risk and low yield form of investment, usually very reliable. The hike in the yields of government bonds almost caused a colossal pension fund sell-off, wiping out the pensions for millions, had it not been for the Bank of England.
Added to all of this, was the mortgage tumult. A necessity for the Bank of England was to raise interest prices to directly tackle the market turmoil, and attract foreign investors to reinvest in British assets again. Given that mortgage lenders try to keep ahead of the bank rate (the interest rate at which a nation's central bank lends money to commercial banks) when setting long term fixed rate deals, it in turn caused major mortgage lenders to suspend handing out new mortgages in order to reprice them. Gone are the days of low-rates, with the average two-year fixed rate now close to 6% up from about 2.2% 10 months ago. Same is true for five-year fixed deals, over 5.5% on average now, up from 2.5% last December.
In all the economic outlook for this month is bleak, but largely an act of policy mismanagement, rather than external factors. Liz Truss appears unlikely to waver from her misstep, even after making a humiliating U-turn on the additional rate of income tax. The market response to a wholesale backtracking of the announcements from the mini-budget is unlikely to undo all the damage caused, since Truss and Kwarteng have introduced substantial policy and political harm to the UK’s international reputation. The pound will likely rally somewhat in the coming month, as markets adjust to the new reality, but economic stability cannot be expected to return until the Government changes substantially.
This post was authored by Connor Escudero, on behalf of the Young Fabians Economy and Finance Network.
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