Friday, the day of Kwasi Kwarteng’s “fiscal event”, was a day for the economic and financial history books, a day of eye-popping one-day moves in UK financial assets that should be of interest to more than traders, economists and economic historians. If sustained, the depreciation of the currency and the surge in sovereign borrowing costs will have important broad-based implications for the economic outlook. And once again, it is the most vulnerable segments of the population who are most at risk.
What was a generally difficult day for global markets was also a brutal day for UK financial assets. The 2% slump in stocks was accompanied by a 3% weakening in the value of sterling against the US dollar, bringing the total depreciation this year to around 20% and to a level last seen 37 years ago. Most historic of all was the surge in yields on UK government bonds, including the largest ever single-day rise in the five-year yield.
While consistent with what was happening elsewhere in global markets – the continuing asset price adjustments to the trifecta of declining growth, tighter financial conditions, and changing economic and financial globalisation with significant geopolitical risks – the moves in UK markets were turbocharged by the specific reaction to the government’s “fiscal event”.
The more traders digested the size and shape of the “big bang” policy announcement, the more they worried about the second-round economic and financial consequences – and the faster they rushed to reflect them in market pricing, resulting not just in large but also disorderly moves.
Traders did not need to wait for the exact specification of the overall cost of the package to decide that investors, both domestic and international, would insist on higher returns to fund hundreds of billions of unfunded tax cuts and energy price stabilisation. Nor did they require much time to figure out that this would force the Bank of England to be even more aggressive in hiking interest rates. An inter-meeting emergency rate rise is no longer out of the question.
The resulting macro policy configuration would be equivalent to a car being driven with one foot on the brake and the other, “pedal to the metal”, on the accelerator – a method that increases the risk of both economic and market accidents. With that comes the realisation of a higher risk of a prolonged period of stagflation (that is, low/negative growth and high inflation), notwithstanding the government’s desire to enhance energy supplies, to put money in people’s pockets and, more generally, improve the functioning of the supply side of the economy.
In such a world, households would face the highly unsettling combination of more uncertain income streams, higher borrowing costs and a further erosion in their purchasing power due to greater imported inflation. Businesses already struggling to keep afloat in the midst of an energy and cost of living crisis would risk being tipped into bankruptcy. At the other end of the corporate resiliency curve, those with robust balance sheets, and who are able to invest in expanding their operations, would spend more time reflecting on the wisdom of doing so at a time when higher costs are accompanied with greater uncertainty about future demand.
This is a world in which the compensating and well-intended surge in economic growth being targeted by the government becomes a lot harder to deliver, especially in the face of strong and increasing global headwinds. Rather than being paid for by rapid high growth, the frontloading of tax cuts that favour the rich risks undermining economic activity and prosperity. The government would face the slippery slope of inadvertently resorting to higher inflation over the medium term to deal with surging debt and debt service. The likelihood of additional industrial action would increase as people sought to protect their already pressured living standards.
No wonder there are already so many comparisons to the 1972 Anthony Barber budget, which ended up fuelling inflation, a recession and a sterling and balance-of-payments crisis.
Fortunately, this is not about the UK facing a 1970s type of economic and financial turmoil that would have the government go, cap in hand, to the International Monetary Fund, as in 1976. The structure of the UK economy and its finances is a lot more resilient this time around. Nor is it about giving up on growth as a critical objective of economic policy. On the contrary: high, inclusive and sustainable growth is the answer to many of our economic, financial, social and institutional challenges. It is an economic and social necessity.
This is about calibrating the design and sequencing of the policy approach in a manner that ensures that the pro-growth and pro-productivity measures are not nullified by counterproductive large handouts to the rich, an overly frontloaded approach and imprudent defiance of global economic realities.
It is about much more targeted fiscal support, and paying greater attention to bottom-up measures that enhance productivity and sustainably deliver high and more equitable growth. It is about the government and the Bank of England working better together to deliver both economic growth and financial stability. And it is about the UK coordinating with the US in particular to enhance international policy cooperation and thereby help lessen the global headwinds to domestic prosperity.
Friday was historic for UK markets. Yet the numbers show us only part of the picture. Behind these numbers is the risk of even greater hardships for millions of families. Indeed, it would be a tragedy if Friday were to end up marking the intensification of a stagflation that hits the most vulnerable segments of the population especially hard and renders the important objective of inclusive, robust growth even more elusive.
Mohamed El-Erian is president of Queens’ College Cambridge. He was chair of President Obama’s Global Development Council (2012-17) and is author of The Only Game in Town
