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Understanding this economic crisis


MAKE no mistake, we face an economic crisis. The view that is being curated is that all was relatively fine until those right-wing barbarians, Truss and Kwarteng, ruined the party with their schoolchild economics focusing tax cuts on the rich and undermining stable public finances. How dare they! They have wrecked it all!

But is it true?

Certainly, if you believe ex-Bank of England governor Mark Carney, the IMF, the Rowntree Foundation, the Institute for Fiscal Studies, timid Tories and the mainstream media, it was those irresponsible tax-cutters. However, the reality is far more complex. 

The last 15 years have seen three major crises: the Global Financial Crisis (GFC), lockdown and now the Ukraine war, energy and inflation crisis. They have all, coupled with the collective response of governments and central banks, played a large part in the current crisis. 

But this one is different from the others. The response to the previous ones was to apply sugar, largely in the form of unorthodox monetary policy, but now monetary policy globally is tightening, as in an inflationary environment it must, and the extraordinary era of ‘free money’ is coming to an abrupt end. The consequences have not yet been felt.

The story should start well before 2008 but for reasons of brevity let’s begin in 2008 with the GFC. Central banks, for honourable reasons, panicked by global financial collapse, adopted highly unorthodox policies. 

In the UK case, interest rates fell from 5 per cent to 1 per cent and the central bank in effect funded the fiscal deficit through a programme of quantitative easing (QE) to buy UK government bonds. This policy suppressed the yield curve, lowering the cost of borrowing to a level well below any credible free market rate. Indeed the rate was the lowest by a margin in the 300-year history of the Bank.

The policy was like giving methadone to a drug addict. Prices were reflated, systemic banking system collapse was largely averted and the economy enjoyed a number of years of growth, suboptimal but at least it was growth. The horror of 1930s-style deflation was averted.

The policy seemed to work but it came at a high cost. Asset prices were distorted, arguably leading to lower productivity and weak trend growth. It enabled a large expansion of the State both in absolute and regulatory terms. The crumpled can was kicked down the road.

Perhaps most significantly, a major taboo was broken. If you could print money to avoid calamity without an apparent great negative side-effect, at least in the short term, might there not be a temptation to use this new-found freedom, away from the normal constraints of tax and spend and maintaining an orderly bond market, in the future? What was unorthodox became orthodox, at least in central bank circles.

In fairness to Cameron and Osborne, they did try to curtail the fiscal deficit, and to an extent after ten long years the country had almost succeeded in a degree of fiscal normalisation. But there had been no attempt at monetary normalisation as interest rates remained, a decade after the crisis, close to zero and £400billion of QE had not been unwound. The same was true in the US and even more so in the eurozone.

Then came the second great crisis and in my view a major policy error: enforced lockdown. The implications of this are numerous and still rupturing across western economies but perhaps the greatest economic one was, for the UK, that the £500billion price tag to hibernate the economy was met by more QE and a lowering of rates even further to a tokenistic 0.1 per cent. Money was indeed free. 

Here QE was far more directly targetedvia furlough, bounce-back loans and the like. Asset prices, notably real estate, fine wine and fast cars went up further in value. It was magic. No need to work any more, just run the presses, enjoy the summer and when it was all over work from home. Marvellous! Except it wasn’t.

All along Government debt was racking up. The sum which from the inception of the Bank of England in 1694 to 2005 had grown to £500billion became £1,000billion by 2010 and Cameron’s election. Today it is £2,400billion and will soon be £3,000billion. In a short generation public debt has increased sixfold. Is it any wonder that confidence in fiat currency is low?  

But by Modern Monetary Theory’s logic it was OK. Print a bit here, withdraw a bit there and the central bankers could run the show, abolishing boom and bust with centralised micro-management.

As we came out of lockdown, however, things went a bit wrong. The low inflation environment the West had enjoyed in some aspects of the economy(by no means all) as a result of China, technology and migratory flows undermining local wages started to unwind.

The great resignation, supply disruption from lockdown, and arguably the monetisation of debt through strongly negative real interest rates started to stoke inflation. Moreover, the State had become so big and so inefficient (at a peak of over 50 per cent of the UK economy in 2020) that the drag was real. Britain (and to be fair much of the West) had transformed from a market-led economy into one where the State was the primary actor led by highly novel monetary policy, to put it politely. All this was before war in Ukraine.

This third big crisis has directly led to escalating carbon pricing sending consumer price inflation in Western economies into the 8-10 per cent range. While carbon prices are volatile it seems to me that inflation will continue to rise, likely peaking around the second half of 2023, and even then may well remain stubbornly embedded as the trickle-through of wage rises, hedging strategies unwinding and margin rebuilding is undertaken. This does not seem like a short-term phenomenon to me. 

Suddenly central banks were forced to tighten monetary policy. It was happening before Ukraine, but the war had greatly added to the pressure. The Fed led, but both the Bank of England and ECB followed. Even then, in the light of inflation in high single digits and predicted to accelerate, UK base rates of 2.25 per cent are pretty paltry. 

The truth is that an unprecedented decade of free money came to an abrupt halt. As can be seen by the chart below, all countries faced a similar conundrum. The UK is not in splendid isolation here, though you would think it was by the political and media response.

Key global 10 year sovereign bonds %

Source: Trading Economics

Then up steps Kwasi Kwarteng. He announces a Budget which under normal circumstances would make a lot of sense. The UK economy he inherited had moved from a relatively free market, low taxed nation to be taxed at its highest rate in 70 years with unheard-of regulatory interference.  

The scale of the tax increases is outlined in the chart below, and we would challenge readers to highlight exactly what public sector improvements have occurred despite these tax rises. The truth very clearly is that the UK has swapped a successful private sector for an unproductive public one with devastating long-term consequences for the prosperity for all.

UK tax burden to GDP

Source: ONS

Kwarteng’s idea of reducing the tax burden by around 1.5 per cent GDP was undoubtedly a good start and will simply take aggregate tax back to where it was in 2021 before Sunak’s tax rises. While we might debate the distribution, that’s hardly radical in a historic context. 

This together with the stated aim of markedly reducing regulation would, in our judgement, in normal circumstances, stimulate growth. But these are not normal circumstances. To announce tax cuts on that scale without explaining how the other side of the equation, spending, would be addressed was, let’s say, highly unorthodox, particularly when a week before Truss had announced an energy cap which, depending on assumptions, will likely cost £200-250billion over two years. In a nutshell, public borrowing would rise from an estimated £55billion next year to around £180billion, declining only slowly thereafter.

While Kwarteng could doubtless point to much higher funding requirements during both the GFC and lockdown, it misses the point. Then there was QE, now there was none. So who would buy the gilts?

On the eve of Kwarteng’s budget, UK 5-year sovereigns, a key benchmark for mortgages, yielded 3.5 per cent. At its worst, before central bank intervention, the yield had moved out to 4.7 per cent. It remains perilously close to that level at the time of writing. 

That’s a huge move, but as we can see from the 10-year sovereign yield chart above this was a global phenomenon as a result of inflation pressures evident since lockdown, exacerbated by war in Ukraine and the subsequent policy to sanction Russia. Both of these decisions were political decisions which made monetary tightening inevitable.

The major error in my view lies with Osborne, Carney, Johnson, Sunak and friends who grew the size of the state so ineffectively, slowly strangling the private sector through tax and regulation but did not regularise monetary policy when the sun shone preferring to sugar the economy and public spending rather than build sound foundations.

Poor Kwarteng delivered a Budget that lacked political nous, for sure, and was insensitive in terms of the balance of tax cuts, but it was absolutely required if the UK economy was to have any chance of breaking the death spiral of tax and spend.

However, to do it without addressing the spending side of the coin, particularly after the energy cap, undoubtedly gave investors an excuse to short gilts and to an extent sterling (although in truth sterling’s performance is not that different from the euro, which has fallen below USD parity). The idea was great, the timing was not.

Yet to equate Truss and Kwarteng with destroying sterling is demeaning politics. The truth is that sanctions on Russia have undermined both UK and EU competitiveness and both currencies have performed, since the advent of war, equally poorly.

But this is not really about currency: it’s about the cost of borrowing and the impact that will have on the economy. In this context the cost of borrowing is rising everywhere, but the reaction to the Budget has been extraordinary in its hostility and co-ordination with attacks from the IMF, Carney and others from the ‘orthodox school of high tax, regulation and control’.

Recession in my estimation is inevitable throughout the West: in the UK, US and EU. The US will likely fare better than the UK, but I would wager the UK should do better than most in the eurozone where imbalances remain great and monetary normalisation is very far from complete.

Any inflationary energy and particularly monetary shock of that magnitude pretty well guarantees problems but should UK sovereigns really yield more than Italian ones, which they do at the time of writing? I rather think not for a raft of reasons, not least total public debt to GDP, which is highlighted below. It seems there is rather too much schadenfreude. The chart shows National Debt to GDP where despite its problems the UK is somewhat stronger than France and close to the EU average. Yielding more than Italian debt, really?

Key European nation Government Debt/GDP

Source: Trading Economics

Don’t get me wrong: the Budget was misjudged. The unfunded tax cuts on that scale were unorthodox. Spending cuts should also have been addressed to normalise the fiscal deficit. The timing was wrong. But the underlying instincts are good and it rather suits the usual suspects to trash the hapless Chancellor, forgetting that their unorthodox monetary policy, tax, spend and regulate policies are the real ones that got us into this mess.

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Ewen Stewart
Ewen Stewart
Ewen Stewart is a City economist who runs the consultancy Walbrook Economics. He is director of the think tank Global Britain and his work is widely published in economics and political journals.

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