What On Earth Just Happened to the UK Economy?
What's just happened to the UK economy? An article on how we got here, and what's next for Liz Truss and Kwasi Kwarteng and where this leaves business.
Here in the UK, we are in the eye of a political and economic storm over which we have very little control - until the next election when we’ll get our chance to have our say. If we’re to navigate our businesses (and personal lives) safely through this storm, then it’s important to have a basic understanding of what’s going on. From here, we can assess the choices available to us and chart a strategy which is true to our vision, purpose and values.
When we’re developing our business strategy, it’s essential that we do so within the context of what’s going on in the world. We do this using a PESTLE analysis, which, if you’re not familiar with the term, stands for Political, Economic, Social, Technological, Legal and Environmental.
Understanding what’s happening in the world from a political, economic, social, technological, legal and environmental perspective means that we can make sure that the roadmap we’ve designed to take our business from where it is now to where we want it to be is fit for purpose. So, what just happened to the UK economy and what does this mean for our business?
So, what just happened to the UK economy?
On Friday, the Chancellor Kwasi Kwarteng unveiled the biggest package of tax cuts in 50 years in his budget, hailing a "new era" for the UK economy. The budget will overwhelmingly benefit the better off. Initially, it will be paid for from additional government borrowing while the ‘Growth Plan’ kicks in.
It is hard to overstate the scale of what has happened over the past few days. The extraordinary market turmoil that was unleashed by Kwasi Kwarteng’s not-so-mini-budget must rank as one of the greatest economic policy errors by the government of any leading economy in recent times.
To put this in context, before the Bank of England intervened on Wednesday morning to quell the panic, traders were likening the carnage in the gilts market to the early stages of the global financial crisis. Pension funds were literally hours from bankruptcy.
How did we get to the point where pension funds were hours from bankruptcy?
Think back to the summer. Liz Truss and Rishi Sunak fought to be prime minister with competing visions on the economy. Sunak’s campaign was focused on being cautious, disciplined, and bringing down inflation. The Truss campaign was all about going for growth, borrowing more, and rejecting Treasury orthodoxy.
Truss enjoyed a big polling lead through the contest and ultimately won. Financial markets were already getting nervy over the summer, with UK assets declining in anticipation of her victory.
To be fair, it wasn't just the prospect of a Truss premiership hitting the pound. The US dollar has been very strong in recent months, due to the Federal Reserve aggressively hiking interest rates (faster than the Bank of England).
A quick explanatory pause: if US interest rates are higher than UK interest rates, that boosts the dollar versus the pound. Investors want to put more of their money in dollar-denominated bonds because the returns are bigger than pound-bonds, so they buy the dollar and sell the pound.
It was in this context that Liz Truss took the keys to No 10. Markets sceptical, the US economy strong, watching closely for her to unveil her economic plans. These were delayed by the national mourning period for Queen Elizabeth II.
It all came to a head on Friday when Chancellor Kwasi Kwarteng revealed their plan, which included the biggest tax giveaways in half a century and an extra £70 billion of unfunded government borrowing to pay for subsidising energy bills. This really spooked financial markets.
Why were the markets so spooked?
Because the past 200 years of British financial history has been a quest for mechanisms to reassure investors, in a country prone to regular crises, that fiscal policy will be made responsibly. Since Britain abandoned the European Exchange Rate Mechanism in 1992, it has relied on three institutional restraints: a strong Treasury that can provide expert advice to ministers; an independent central bank; and the Office for Budget Responsibility.
When Kwarteng stood up to speak on Friday, he and Liz Truss had undermined all three of these mechanisms. Intentional or not, they sent out negative signals to investors which made the government look less safe and trustworthy. When it comes to the markets, perceptions are crucial.
By firing Sir Tom Scholar, the Treasury’s permanent secretary, on his first day in the office, Kwarteng sent a signal to investors that he was not interested in expert advice.
The incessant attacks on the Bank by Liz Truss’s leadership campaign over the summer raised doubts about the new government’s commitment to keeping inflation low.
The chancellor circumvented the scrutiny of the OBR by refusing to allow it to provide a public forecast of his budget policies.
This created a perfect storm, and the markets delivered their initial brutal verdict on the Kwarteng plan. The pound slumped, UK bonds fell. Kwarteng then made matters worse over the weekend by saying he wanted to press ahead with more tax cuts - amplifying the message and gung-ho approach that had spooked the markets.
So, when the markets opened on Monday and the pound crashed to an all-time low against the dollar, the pound’s weakness had a significant real-world harm for the UK. It made imports more expensive, and Britain imports a lot more than it exports. This means higher costs for businesses which will get passed on in the form of higher prices to customers - which will fuel inflation.
Meanwhile the UK's borrowing costs started to rise quite alarmingly. (Another quick explanatory pause: when bonds are falling, their `yield' rises e.g., the debt interest you pay on the bond. Falling government bonds led to higher costs of borrowing which is bad for the public purse.
With an extra £70bn needed to pay for the government’s big energy support package, now is a particularly bad time for borrowing to be more expensive. While the real-world harm of high government borrowing costs means that more money is spent on servicing debts in interest payments, rather than on public services, schools and hospitals. This will inevitably lead to cuts in public services and infrastructure which are essential if businesses are to thrive.
In response to the pound dropping on Monday, Kwarteng and the Bank of England went into attempted stabilization mode. They both put out statements trying to reassure the markets, but with limited success.
The situation calmed a little on Tuesday but was still very volatile. Then the International Monetary Fund came out and gives the UK a slap down over its economic plan. A BIG embarrassment for a major economy.
And then we come to Wednesday, when the Bank of England made an emergency intervention, saying it would step in and stave off a crash by buying long-dated bonds. It was looking very hairy on Wednesday morning because pension funds particularly were in a bind. By this I mean they were hours from insolvency.
Pension funds are some of biggest holders of long-dated government bonds and had obviously seen the value of those plunge in the last few days. They really needed help. Hence why the Bank of England stepped in to calm markets after some types of pension funds were at risk of collapse.
As of the time of writing this article, the EU are now very concerned about contagion risks the UK government's fiscal actions pose to financial stability in the Eurozone. That’s because a lot of Euro area banks and insurance firms are exposed to UK gilts. The European Commission is very worried. The IMF is worried. And the White House is worried.
What now?
So, what now for Kwarteng and Truss? They've created a situation verging on a financial crisis, requiring the central bank to step in to make amends for their economic plan. And there’s fear of wider contagion.
Their options are:
No U-turn, battle on, hope the markets improve and ride it out. This strategy effectively relies on quite a bit of crossing of the fingers. Not a sustainable plan if the markets continue to move against them.
U-turn, drop parts of the economic plan i.e. row back on the top rate tax cut, shift strongly and relentlessly to a message of fiscal prudence, apologise, say you tried to do too much too quickly, bite the bullet and hope the markets reward you. This is not guaranteed either.
Both options will result in essential public services being slashed and interest rates sky-rocketing. Otherwise that's it really. Whether Truss and Kwarteng sticking to their current course is sustainable will depend on behaviour of the markets - and whether Truss’ MPs allow her to go on. Next week’s Tory conference will be interesting.
So, where does this leave businesses?
It’s about a methodical assessment of the situation, patient scrutiny of the strengths and weaknesses of your business and those of your competitors and thinking logically and long so that when the opportunities come – and they will – you're ready to make the most of them.
In other words, a carefully considered and executed approach strategic planning which involves a leadership rather than managerial approach, something women in business excel at.
Read: 3 Guiding Principles To Steer Your Business Through A Cost of Living Crisis
About The Author
I’m Denyse Whillier, and I was a Chief Executive for 8 years, I spent 25 years in senior management and leadership roles and trained at Cranfield School of Management. I made the leap from corporate to founding my boutique business consultancy and have worked with a wide range of small and medium sized businesses, many of which are purpose-led. My mission is to close the gender gap in business and make it easier for women to start, grow and scale a successful business without compromising their values.
Whatever circumstances you find your business in, know that you’re not alone – and that I’m here to support you. An experienced and empathetic business advisor can make a massive difference to your business – as well as to your own sanity – so do consider getting in touch to book a friendly (and free) chat at any time. I’m always happy to talk you through how I could help. For examples of my work, check out my portfolio of case studies.