The UK mini-budget is a stark warning to policymakers

The UK government may be forced into an undesired and politically unpopular spending squeeze to ease market concerns over its tax-cutting budget, but the promised ‘bonfire’ of regulations also has serious risks.

Expert comment Published 29 September 2022 3 minute READ

The UK chancellor’s so-called ‘mini-budget’, which includes £45 billion of discretionary debt-funded tax cuts on top of essential spending to cap energy prices, has led to a wave of criticism at home and abroad and a severe market rout.

UK long-term bond yields at one point rose by 150 basis points forcing the Bank of England to step in on 28 September to preserve orderly market conditions and sterling’s exchange rate has touched an all-time low against the dollar.

By any standards this is an extraordinary response, and there are two channels through which the budget could have significant economic implications internationally.

Risk of international spillovers

The immediate question is whether the negative market reaction in UK debt and foreign exchange markets will continue and add significantly to global economic and financial fragility, particularly when this is set against a backdrop of geopolitical tensions, the global energy crisis, and the broad consequences of rising US interest rates and a strengthening dollar.

A senior Fed official expressed concern earlier this week that the economic fallout from the budget in the UK could have implications for growth in the European Union (EU), and hence the US. The International Monetary Fund (IMF) and the US Treasury Secretary have also said that they are monitoring the situation in the UK closely.

The immediate question is whether the negative market reaction in UK debt and foreign exchange markets will continue and add significantly to global economic and financial fragility

With an eight per cent current account deficit and the continuing impact of Brexit on its trading performance, the UK is clearly vulnerable to further market anxieties. But, despite yesterday’s bond market intervention, it is most likely the markets will eventually stabilize at new levels reflecting the changed policy mix. There are, after all, no institutional rigidities – such as the Exchange Rate Mechanism of the 1990s or an externally imposed fiscal framework – for the markets to break through.

In addition, the UK economy accounts for just three per cent of global GDP which means, even if there is a sharp UK downturn, the impact on the global economy would be relatively modest. And although sterling remains one of relatively few widely-traded, fully convertible reserve currencies, it accounts for just five per cent of central bank reserve holdings.

The UK authorities will have to balance the benefits of the new steps to calm the markets with the risk of making matters worse.

The Bank of England’s chief economist has said there will need to be a significant monetary response to the events of the past week, but the Bank will be keen to do this as part of the Monetary Policy Committee’s regular decision-making cycle. Former UK Chancellor George Osborne quickly reversed significant elements in at least one of his budgets and survived, but the markets were not involved.

A second question is how the UK budget and subsequent reaction may affect future policy choices in the UK and other countries.

The UK’s experience provides a strong deterrent to attempts to boost growth through general tax cuts funded by taking on more debt. The IMF statement on 27 September stated that, given elevated inflation pressures in many countries ‘we do not recommend large and untargeted fiscal packages at this juncture… It is important that fiscal policy does not work at cross purposes to monetary policy’.

This is particularly so for countries which cannot rely on the protection of issuing the global reserve currency (US), or having very loyal and dominant domestic investors (Japan), or being part of a broader group with powerful common institutions able to provide financial support (EU member states).

Dangers of incomplete policies

But the reaction to the UK mini-budget is also as much to do with the fact that the policy package is incomplete – lacking both the independent forecast of the Office of Budget Responsibility (OBR) and a medium-term fiscal sustainability plan – as it is to do with the specific policy measures it contains.

This led the Institute of Fiscal Studies to predict an indefinitely increasing debt/GDP ratio, and the UK government has said it will provide both elements in its full budget on 23 November – but doing so in a manner which satisfies both the markets and UK Conservative party is likely to prove difficult.

The OBR is likely to be much more pessimistic on the productivity/growth dividend from tax cuts than the government has been

The UK government may argue that a rapid acceleration in the re-balancing of monetary and fiscal policy – as the Bank of England responds to increased fiscal stimulus by raising interest rates – will reap benefits. This could occur if the ‘normalization’ of nominal interest rates after more than a decade at ultra-low levels boosts productivity by driving out poor performing businesses (although the policy also poses substantial financial risks, particularly given the impact on residential mortgage rates).

But even with this and a suit of new de-regulation measures, the OBR is likely to be much more pessimistic on the productivity/growth dividend from tax cuts than the government has been.

If this happens, then unless the UK government says it disagrees with its official forecaster or that it is happy to tolerate unsustainable debt – either of which is likely to trigger further market disruption – the only way to square the circle is by introducing sharp and politically unpopular expenditure cuts.

The UK government’s deregulation package could have more international resonance, particularly with conservative US politicians. The mini-budget is an initial taster and indicates the government plans a substantial easing of post-global financial crisis constraints on the financial sector, including lifting a cap on bankers’ bonuses, while retaining a special banking tax designed to fund future government interventions.

The UK mini-budget is a stark warning to policymakers 2nd part

It also seems likely to downplay, or even reject, important regulatory and tax-based approaches to achieving net zero while still maintaining the UK’s legal commitment to the target.

But at a time when policymakers and businesses around the world are giving top priority to raising resilience in the light of shocks from the pandemic, extreme weather, and the war in Ukraine, the UK government needs to think through – and set out clearly – how resilience can be maintained alongside the deregulation measures.

The UK already has bitter experience from BSE (bovine spongiform encephalopathy), known as ‘mad cow disease’, in the 1990s, and the financial deregulation in the 2000s, of the enormous economic and social costs caused by poorly-devised deregulation. It would be tragic if such errors were to be repeated.