UK Financial Crisis
The UK is currently experiencing a turbulent political and financial period. Ex-UK Prime Minister Liz Truss left office on Thursday, October 20, just 45 days after taking office, making history as the leader of the country with the shortest tenure ever. Despite her brief tenure, she had a considerable impact on the country heading for recession.
What did Liz Truss do to require her resignation from her position after just 45 days? This article will explain the UK’s economic condition, Liz Truss’ mini-budget and why it was received poorly.
State of affairs:
The UK’s financial predicament all started with the 2008 crisis. The government was forced to bail out the banking sector. It intervened in various ways to support the banking industry as a whole and a handful of banks in particular. It injected £137 billion of public money in loans and capital to stabilize the financial system.
Unemployment rate rose to historic highs with more job losses in the retail sector. The recession had a significant negative impact on the manufacturing sector, which decreased by 12.3%. Overall output decreased by 6.2%. Even today, the output of finance and insurance businesses and labor productivity are still below pre-2008 levels.
Image Courtesy: Economic Output of Finance and Insurance sector
As Britain was recovering from the recession, the calls for Brexit were first heard. In June 2016, British citizens voted to leave the European Union (EU). On 29th March 2017, the Brexit deal was proposed for the first time by the new British government led by Theresa May. The uncertainty in the market due to Brexit negotiations slowed down the UK economy from 2.4% in 2015 to 1.6% in 2019. International investors withdrew from the UK market because of the unpredictability. Trade remains a driver of economic prosperity but the finalization of the Brexit deal led to a 40.7% drop in exports to the EU once the new trade agreement went into effect.
In Britain, the CPI hit 10.1% in September 2022. One element driving up inflation is increase in consumer goods’ prices, which is supported by high consumer demand and supply-chain bottlenecks. Energy expenditures, including rising household energy tariffs and gasoline prices, are a significant contributor to inflation. Following the start of Russia’s full-scale invasion of Ukraine, gas prices reached record highs and continued to rise for the majority of 2022 due to shortages of Russian supplies.
Millions of Britons run the risk of not being able to maintain a decent standard of living due to rising household expenses and the fact that incomes have not been adjusted for inflation.
Image courtesy: Inflation in UK
Image courtesy: Cost of living in UK
The contentious mini-budget:
Liz Truss proposed the controversial mini-budget on 23rd September to tackle all of these issues. It was designed to achieve 2.5% annual growth with no plans outlined as to how it will be accomplished.
The mini-budget focused on tax cutting and increasing liquidity in the market. Tax cuts worth £45 billion were announced including cuts in stamp duty, income tax and the additional 45% tax paid by the wealthiest income tax bracket. Cuts in stamp duty would stimulate the real estate market and incentivize people to buy houses as the costs would go down.
No measures to raise funds were announced to finance the tax cuts. Instead, major borrowing schemes were introduced. Experts believed this would lead to a debt-borrowing spiral.
Increasing liquidity in the market increases consumption, investment and leads to economic prosperity. So the mini-budget taken as is, is not a terrible strategy. However, if we take into account the prevalent and persisting inflation in the economy, increasing liquidity would do much more harm than good. We must also consider the fact that other nations across the world were attempting to reduce market liquidity by raising interest rates, while Liz Truss intended on lowering interest rates, further discouraging foreign investors, who then began selling the British pound.
Political parties and markets responded disapprovingly with the pound plummeting against the dollar. When additional tax cuts were announced, the bond market experienced turbulence. In an unprecedented move, the Bank of England announced a two week program to buy long term bonds. This was done to restore orderly market conditions as UK pension funds were in jeopardy due to falling prices of bonds.
Image Courtesy: Pound to Dollar after announcement of mini-budget
The time ahead:
According to the Bank of England, the British economy is witnessing its longest recession since records began. They predict that the UK will be in recession that will start in the third quarter of 2022 and last until the middle of 2024. They also forecast a doubling of the unemployment rate throughout this time.
The newly formed government’s objective is to keep inflation in control. The latest hike in interest rate was on 4th November. It was increased by 75 basis points to 3%. Increasing interest rates is essential to controlling inflation but, as a result, recession would last longer. The increase in interest rates would also worsen the cost of living crisis.
Prime Minister Rishi Sunak has taken on the daunting mission of reestablishing Britain’s credibility in foreign markets. He hinted at tax rises to calm the market.
“I think everyone knows we do face a challenging economic outlook and difficult decisions will need to be made,” Sunak, a former UK finance minister, told parliament.
On November 17, Chancellor of the Exchequer Jeremy Hunt will present the financial statement where spending and tax policies will be laid out.
Britain has been through setbacks, misfortunes and hardship in the last decade. Its position as a financial center was questioned and its image as one of the leading economies in the world was tainted. The unenviable burden of guiding Britain out of this dilemma lies on the shoulders of the British government and Central Bank. What the country needs more than anything during these daunting times is a stable government.