The weather forecast: an unstable, low-pressure system with resulting gloom
The entire UK economy seems to have been afflicted by long Covid. Nothing seems to work anymore: strikes abound; there are labour shortages everywhere; and inflation is rampant. The UK economy grew by 0.8 percent in the first quarter but in the second it flatlined. Then the Conservative party had an unedifying nervous breakdown and forced out its prime minister.
There is a prevailing sense – apparently shared by Bank of England (BoE) governor Andrew Bailey – that we are sliding into recession. Bailey told the European Central Bank conference in Portugal last week: “I think that the UK economy is probably weakening rather earlier and somewhat more than others”. Inflation is expected to reach 11 percent in the third quarter. Food prices are set to surge further in the autumn as shortages set in and the energy price cap will be revised further upwards in October.
In his first interview on becoming the new chancellor, Nadhim Zahawi MP admitted that 2023 is going to be “a terrible year”. As the cost-of-living crisis intensifies, discretionary spending will contract – there are signs that is happening already – which will reduce demand.
Sterling in retreat
The pound has had a bad year to date and things could get worse. True, the big currency story of 2022 has been the ‘invincible’ dollar. That is well understood: the ‘greenback’ is the safe-haven, must-have currency in times of geopolitical stress. And the US is self-sufficient in hydrocarbons – unlike any large European country – at a time of surging oil and gas prices. But the inherent weakness of sterling has been underestimated.
The pound started the year at around $1.35 but this week plunged below the benchmark $1.20 level. It could get worse because most analysts think that the UK is headed for imminent recession – though so is the US and much of the EU. UK growth ground to a halt in the second quarter. But more significantly the growth potential of the UK economy is shrinking, so there is less chance of a strong rebound when current inflationary pressures (principally energy and food-price rises) slacken.
Even more concerning is that the UK’s structural trade deficit is deteriorating rapidly. In the first quarter of this year, the UK’s trade balance amounted to £52bn − a post-1955 record deficit of 5.2 percent of GDP, with nearly half of that from rising energy prices. In 2004, the UK became a net importer of fossil fuels, as oil and gas production from the North Sea fell. Today, our domestic output of oil and gas is around 30 percent of the peak level in 2000. Overall, the UK goods deficit has risen from three percent of GDP in 2000 to 10 percent in the first quarter of this year.
Decades of running trade deficits has resulted in capital flight. The net international-investment position – that is, the difference between assets owned by UK entities overseas and UK assets owned by foreign entities – fell to minus 32 percent of GDP by the end of last year, according to Gavekal Research with Macrobond. It was last in surplus in the early 1990s; but since the reign of Margaret Thatcher all UK assets seem to have been up for sale – and many were bought by the Chinese in the Cameron-Osborne era.
Thatcher’s government was the last to attempt to reform the UK economy with supply-side measures to boost productivity, innovation and entrepreneurship. Since the early 1990s, successive governments have adopted a “progressive” approach whereby the political agenda prioritises supplicating interest groups rather than growing economic capacity.
Rishi Sunak demonstrated, in my view, the endpoint of an ideology that believes that all problems can be solved by throwing other people’s money at them – something Thatcher warned us about. We just didn’t know what fiscal gimmick the Johnson-Sunak ‘circus’ would come up with next. It included the eat out to help out scheme, the social-care levy (which everyone knows will not improve care of the elderly but will be gobbled up by an unreformed NHS) and hiking corporation tax at a moment when our French neighbours are cutting theirs.
From 1981 to 2004, UK GDP per capita (in US-dollar purchasing-power parity terms) outpaced most rival economies. In the UK, living standards rose from 73 percent of US GDP per capita to 80 percent, and from 72 percent of German GDP to 95 percent. This progress has since reversed, with UK GDP per capita retreating by eight percent against Germany and returning to 1981 levels relative to the US. So, the UK was getting poorer in comparison with our major peers even before this economic ‘tsunami’ hit our shores. Now, the fear is that the UK will weather this storm worse than others – that is apparently what Bailey believes.
Thatcher and her successor, John Major, were the principal architects of the European Single Market (inaugurated 1992) which, as we know, the UK left definitively on 1 January 2021 (just in time for Covid). Right now, the consequences of Brexit seem to have been entirely negative: though there are economists whom I respect such as Liam Halligan and Gerard Lyons, who point out that there was always going to be short-term turbulence before the advantages of Brexit became manifest. Furthermore, Brexit has not enabled us to address illegal migration – and legal migration from the EU was never a problem, in my view. The civil service is clearly averse to departing from any European regulations, so a sense of stasis has developed.
Then there is the tragic denouement of the Johnson government. Whatever readers may think of his character and suitability, the mainstream media decided that Johnson was not the man for the job and every stumble was leveraged into a catastrophic pratfall. It was not just the Guardian et al – even the Telegraph put the boot in, daily. This influenced public opinion. The Conservatives have lost four seats in by-elections in the last year alone and Labour is currently about 10 points ahead in the opinion polls.
This government has been losing credibility and authority – despite (or perhaps because of) its radical environmental agenda, which will deprive country types of their wood burners and oblige them to plough up their gardens to install ground-source heat pumps. On Tuesday evening, the resignation of the chancellor and the health secretary within a half an hour of one another sealed the PM’s fate, although it took another 36 hours for the chain of dominos to fall.
When foreign-currency traders and investors looked at the UK on Tuesday, they saw a growing wave of industrial strife and a government which was about to pick a fight with the EU over the Northern Ireland protocol which it couldn’t win. They are now uncertain about what sort of government will emerge over the summer.
A weaker pound means that imports, including hydrocarbons, will become more expensive, thus further stoking inflation. The pain will get worse before it gets better.
The public purse
In his resignation letter submitted on Tuesday evening (5 July) Sunak intimated that there were serious policy differences between himself and the prime minister. It would have been preferable if either he or Johnson had had an economic policy on which they agreed – but alas there was no sign of any such thing under this government. Rather, there was a reflex to throw money at each issue as it arose.
One of Sunak’s last measures of largesse was to promise pensioners an inflation-busting rise – while advising employees to moderate their pay demands. He was apparently against widescale tax cuts because he believed that, by stimulating demand, inflation would be further stoked. But that was to overlook that the inflation we are experiencing is of the cost-push rather than the demand-pull variety.
It’s clear that there will have to be spending cuts over the medium term to avoid ballooning national debt. Yet in the last week, the exiting Johnson government has pledged to increase defence spending from 2.0 to 2.5 percent of GDP by 2030. It should be 3.5 percent in my opinion – but that is another conversation. Meanwhile, many welfare benefits are inflation-linked. Interest costs on government debt are about to surge. The so-called social-care levy is likely to be entirely consumed by imminent wage rises in the NHS. How will the circle be squared? None of the prospective candidates for the top job seem to know.
On Thursday (7 July), the OBS issued a report which affirmed that UK public finances were on an “unsustainable path”. The electrification of transport will deprive the Treasury of about £30bn in revenue from fuel duty which shall have to be found elsewhere. The new chancellor (or his successor) will have to address this.
The historical aberration of negative and near-zero interest rates is now coming to an end. Over the next three-five years rates will regress to their long-term mean in the UK of around four-five percent. The futures markets now expect UK rates to reach three percent by the end of next year. This will affect the large part of the population who are highly indebted – ie people who have mortgages and credit card or other consumer-finance liabilities which they roll over each month. But it will also impact government finances, since the borrowing splurge conducted by successive Tory-dominated governments was conducted on the heroic assumption that interest rates would remain low indefinitely.
In the last few months, many commentators have begun to question why the BoE continued with a programme of quantitative easing (QE) throughout the pandemic and kept interest rates so low for so long. It was clear that a tsunami of inflation was heading our way back in the first quarter of 2021. I wrote a piece here about the wolf of inflation in March last year. Yet the BoE sat on its hands. The formal inflation target is just two percent. The governor and the Monetary Policy Committee have been neglectful in their duty to restrain inflation.
Last year I questioned the conventional wisdom amongst the ‘priestly caste’ of central bankers that inflation was “transitory”. Now the fear is that it might become embedded. As the BoE stands on the sidelines, like a dazed pedestrian gawping at a road-traffic accident, the modern orthodoxy of central-bank independence becomes questionable. Central-bank independence has failed, and the new chancellor should reassert Treasury control over interest rates.
Then there are the deep structural economic problems within the UK economy.
The labour market is as tight as it’s ever been with job vacancies at a record 1.3 million. The hospitality and aviation sectors are desperately short of staff. Farmers are lacking fruit and vegetable pickers. The government has introduced several visa schemes for specialist workers such as butchers, on an ad hoc basis – and no doubt many Ukrainian refugees will enter the labour market in the year ahead. But there is a growing perception that ending freedom of movement under the Brexit withdrawal agreement was damaging – though Labour is now committed not to reverse that move (even if Tom Tugendhat MP is).
There are more than five million working-age adults who have quit the labour market for one reason or another.. Official unemployment figures discount people who have left the jobs market but say they are not seeking employment. About one in five of these people in some parts of the UK are claiming out-of-work benefits. Anyone on Universal Credit can desist from reporting to a ‘work coach’ if they work for nine hours a week. Secretary of State for Work and Pensions, Denise Coffey MP, wants to increase that to 12 hours − and possibly more.
Another strategic weakness is that key UK industries are highly reliant on imported steel. The nuclear and defence industries spent £150m on steel last year – but just £45m came from UK mills. Nuclear-industry insiders complain that the required grades of steel are not being manufactured in the UK. Even in the late 1960s, the UK was the world’s fifth-largest steel producer – though it was 18th by 2015. The main reason for the decline is that energy costs have risen in the UK faster than elsewhere, especially since the net-zero carbon by 2050 target was imposed.
Then there is the productivity issue. I have previously argued here that the UK does not compare as badly with our OECD partners because, as a metric, output per hour worked favours countries with inflexible labour markets and high unemployment (like France). Most top-tier UK manufacturing, like the Nissan plant in Sunderland, has productivity levels equal with automotive plants in Germany. That said, there is a huge lack of training and apprenticeships. The young are not being prepared adequately for the world of work.
Johnson and Sunak were supposed to make a joint platform on a “plan for growth” this month – which Sunak referred to in his resignation letter on Tuesday. It’s not clear now whether such a plan will be forthcoming until after the next PM takes over.
All this is unfolding against a backdrop of deteriorating demographics. In the UK, over-65s now outnumber under-15s for the first time ever (9.9 million compared to 9.3 million). We have more than half a million nonagenarians. According to ONS data further to the 2021 census, the 70-79 age bracket is booming. That is the age bracket which consumes most NHS resources and lives on state retirement pensions. The baby boomers are getting older – and more expensive.
Inflation has political costs as well as economic ones
The last time there was a protracted bout of inflation across the western world, every single democratically elected leader was driven from office, culminating in the fateful year of 1974. History repeats itself, as Karl Marx wrote, first as tragedy and then as farcei. Governments have already fallen in Estonia (where inflation is at 20 percent) and Israel. Joe Biden’s chances of running again in 2024 are minuscule. Johnson is out. Emmanuel Macron has been rendered lame by the French parliamentary elections. Mario Draghi is on his way to the exit. Pedro Sánchez is losing his grip on power in Spain.
Modern western electorates do not like the erosion of their purchasing power, even if they understand that there are long-term global forces in play. Medieval peasants had more forbearance than their modern counterparts who can compare lifestyles with their peers. They see friends cavorting on Instagram in Ibiza and Dubai and feel aggrieved that they can’t join the fun.
The next three years are likely to be turbulent in Europe and in the US. Johnson’s departure will be the first of many.
The Tory government under Johnson lacked ideological coherence. The “Levelling Up” agenda, while worthy, gave no clue as to how to raise productivity or boost economic growth. It focused on bus networks (which should be the preserve of well-run local councils), ‘white elephants’ like HS2 and building fuel-inefficient homes on greenfield sites. What we really need is lower energy costs for manufacturing, ‘smart’ finance for innovation and a tax system that favours entrepreneurship.
The tragedy of Johnson’s fall is that he was the charismatic leader who was supposed to make great things happen and to seize the opportunities afforded by Brexit. Of course, his ambitions were stymied by protracted Brexit turbulence, the coronavirus pandemic and then a cost-of-living crisis precipitated largely by a highly dangerous war in Europe. But he compounded these challenges with chaotic management of the Downing Street ‘machine’ (how Dominic Cummings must be smiling this week) and by a deep-seated tendency to cut corners. Even Johnson’s champions whom I know admit that he just didn’t have the right people around him. Character is destiny.
Evidently, the next PM will have to be a person of huge insight, intellect, foresight, integrity and inspirational leadership. I’m not holding my breath.
What the markets make of it all
The first half of 2022 was dismal for the world’s leading equity markets. The MSCI World Equity Index shed 20 percent. The NASDAQ lost $5.4tn in market cap. Alternative assets don’t look appealing either. Crypto currencies have been in freefall. The FTSE indexes have avoided agony because there was never really a bull market in London in the first place. These market woes are probably as much to do with the strange death of QE as the war in Ukraine.
There have been 17 bear markets since 1945, and they typically last around a year. The new PM might take comfort from that. In response to Johnson’s resignation the pound and the FTSE rose modestly.
Hope springs eternal.
One month ago, I wrote here: “It might well turn out that different skill sets are required to “Get Brexit Done” than to “Make Brexit Work”.
I’m flattered that Sir Keir Starmer said almost exactly that in his speech on European policy on Monday (4 July). But for Remainers, Johnson’s fall is a chance to restart the Brexit civil war. Lord Heseltine told The Telegraph: “If Boris goes, Brexit goes”.
I fear that the Brexit ‘ding-dong’ – “a tedious argument of insidious intent”, as TS Eliot might have put itii – is about to kick off again.
i The 18th Brumaire of Louis Bonaparte (1852)
ii The Love Song of J Alfred Prufrock (1915)