Geoeconomic fragmentation poses serious challenges for the UK

The UK faces serious domestic challenges with limited scope to use fiscal interventions to address them, a policy dilemma that will be exacerbated by wider geoeconomic and geopolitical forces.

Expert comment Published 9 June 2023 4 minute READ

Stephen Pickford

Senior Consulting Fellow, Global Economy and Finance Programme

The latest IMF assessment of the UK economy contained some welcome good news. Compared to its projection only a month ago that the UK would be in recession this year, the IMF is now forecasting modest growth of 0.4 per cent in 2023. The Bank of England has also upgraded the prospect for real GDP growth over the next year by over 1 percentage point.

UK domestic challenges

But it is important to put this good news in perspective. In the short-term, the UK’s economic performance is still expected to be near the bottom among industrialized countries; inflation remains high and persistent; and in the longer term, the UK’s continuing poor productivity performance will remain a drag on growth and living standards.

While some of these short-term problems have been exacerbated by events abroad, such as the war in Ukraine and the resulting hike in energy and food prices, and disruptions to international supply chains during the COVID-19 pandemic, other problems are specific to the UK – and some have been self-inflicted. The rise in the numbers of economically inactive are related to the pandemic itself, but also to the problems facing the NHS which have prevented many sick from accessing effective treatment. And despite continuing increases in net inward migration, many firms report that they are unable to recruit sufficient skilled labour.

The rise in the numbers of economically inactive are related to the pandemic itself, but also to the problems facing the NHS which have prevented many sick from accessing effective treatment.

There are signs also that inflation has become more entrenched in the UK than elsewhere. Contrary to market expectations, UK core inflation rose further in April, and a rising proportion of it is domestically generated. While some prices, such as mobile phone contracts, are tied to the Consumer Prices Index (CPI), the Bank of England has warned that less competition from European companies is allowing UK companies to raise prices further. Many wage negotiations are also seeking to match high inflation levels, exacerbating upwards pressures from labour shortages.

Finally, the ‘fiscal event’ of the short-lived Truss government in autumn 2022 provided a further source of stress and uncertainty to the UK economy. The market reaction to the tax-cutting strategy unveiled in the mini-budget was swift and brutal. Even though interest rates initially fell back after the mini-budget measures were reversed and further consolidation measures put in place in the March budget, public sector net debt is forecast by the OBR to continue rising as a proportion of GDP over the next four years, demonstrating the lack of fiscal room facing the government.

Policy dilemma

The current government priority is to get inflation down to its 2 per cent target and start to reduce fiscal deficits and debt. It also aims to help the economy grow faster by increasing the number of people in work. While unemployment remains low by historical standards, this reflects the increase in the numbers of economically inactive and very low productivity growth. The sluggish rate of economic growth forecast by the IMF is likely to see unemployment rise further over the next two years.

The policy dilemma in the short term is how to reduce inflation without damaging growth.

The policy dilemma in the short term is how to reduce inflation without damaging growth. The priority of the autumn 2022 mini-budget was growth, generated through tax cuts; but this was derailed by the negative market reaction. The current priority is to reduce inflation quickly, which almost certainly means both monetary and fiscal policy will have to remain tight for some time.

The longer-term challenge is the UK’s long-standing and well-documented poor productivity performance. Improving this is key to sustained economic growth over time, but the IMF’s staff assessment is that the UK’s trend rate of growth is only 1.5 per cent a year. The two main drivers of productivity growth are improving the quality of the labour force and raising the quantity and quality of productive investment. But neither of these are easy to do, nor can they be achieved quickly.

Enhancement of the labour force requires training and education, which is likely to take many years to bear fruit. Investment enhancement can be achieved more quickly. Given that domestic savings (especially public resources) are likely to be constrained in current circumstances, a speedier route is by attracting foreign capital, especially foreign direct investment (FDI). This may also be more productive, as foreign investment often brings with it state-of-the-art technology and increased competition, which pushes domestic firms to become more productive and efficient.

A fragmenting global environment

The UK has many attractions as a destination for FDI but Brexit has undoubtedly made it a less attractive option because of restrictions on exporting to the EU.

This is one aspect of what the IMF has termed geoeconomic fragmentation. Its latest World Economic Outlook highlights several recent events which are causing greater unwillingness to rely on multilateral trade, investment and technology. Instead, there are pressures to place more emphasis on self-reliance and good relations with geopolitically aligned countries, so-called ‘friend-shoring’. Brexit, trade tensions between the US and China, and Russia’s invasion of Ukraine are examples of this trend, which poses a challenge to international economic and political relations.

More broadly, increasing public disenchantment with globalization is encouraging more inward-looking policies. A significant example is the recent introduction of the Inflation Reduction Act (IRA) and the Chips Act in the US, providing over $400 billion in tax credits, grants and loans to support a domestic semiconductor industry and clean-tech manufacturing. A key aim is to counter China’s increasing importance in strategic sectors, such as semiconductors and electric vehicles, and attract foreign investment and jobs. The legislation is so extensive in scope that the EU is developing its own package of subsidies. 

The IMF concludes that this fragmentation will lead to large output losses and negative spillovers for the global economy, especially for countries that lose out as investment is relocated elsewhere.

The UK faces serious domestic challenges with limited scope to use fiscal interventions to address them, a policy dilemma that will be exacerbated by wider geoeconomic and geopolitical forces. If geoeconomic fragmentation persists, and possibly strengthens, it will increasingly impact international relations, put globalization into reverse, and impact negatively on living standards across many countries.

As an open and relatively small economy, the UK is likely to be particularly affected by these forces. It may need to follow the lead of the US and the EU and provide further industrial subsidies – for example for battery ‘gigafactories’ – or lose out in the competition to attract and retain high-tech and clean energy industries. But its limited financial resources mean the UK must build coalitions with bigger partners – including closer cooperation with the EU and the US on science, technology and regulatory issues – or risk losing out in a fragmenting global environment.