Britain is finding itself in a bit of financial turmoil. In the wake of the new Conservative government’s mini budget a few weeks ago, the international financials markets sold British Pounds and government bonds, signalling a lack of confidence among investors in the British economy and the government’s policies. The abolition of the top marginal rate of tax got a lot of press, but of course, the reality is a lot more nuanced and complicated than what is being portrayed in the media and suggested by opposition politicians, who are keen to paint the problems simply as the fault of an incompetent government, rather than being caused by structural problems which have built over decades as a result of fundamental policies which broadly have enjoyed support from across the political spectrum. But it is indeed a whole host of fundamental economic problems that are now beginning to undermine the financial stability of Britain.
Perhaps the most obvious of these imbalances is the almost unimaginable indebtedness of the government, which has consistently spent a lot more than they have taken in taxes: government debt stood at £2.4 trillion in August 2022, excluding unfunded liabilities such as more than £1 trillion of pension commitments. And needless to say, the government has no plan whatsoever to address the debt. Politicians pay lip service to the recklessness of unfinanced tax cuts or spending commitments, but the public sector is set to run a budget deficit 3.9% of GDP, or 99.1 billion pounds in the 2022/23 fiscal year, and no one seems concerned. With no political will from either party to cut spending, there are no prospects of the government ever running a surplus again, something they last did in 2000. On the contrary, the government is now committed to fighting an energy crisis, at the potential cost of hundreds of billions of Pounds, and, as a result of rising interest rates, there is a mortgage crisis brewing, which there will be huge pressure to also solve with an unfunded government bail-out.
And it is not just the government who is addicted to deficit spending: as a nation, Britain is consuming a lot more than it produces. The current account, which measures the difference between imports and exports of goods, services and investment income, was in deficit by £33.8 billion, or 5.5% of GDP, in the second quarter of 2022. This means that the UK, as a whole, is effectively borrowing more than 5% of everything we spend from abroad, which reflects underlying problems in the relationship between our short-term consumption and longer-term investments.
As a result of the many imbalances in the economy, and exacerbated by the economic catastrophe that followed in the wake of the Covid lockdowns, the Bank of England has moved away from its stated primary mandate of maintaining price stability to play a role which is ostensibly more focussed on avoiding financial turmoil and ensuring that the government can continue to fund itself. The bank has two basic instruments at its disposal: interest rates and money supply, and it has used both to the max, cutting interest rates to 0.1% and expanding its balances sheet through QE, from less than £100 billion before the 2008 financial crisis to almost £1.1 trillion today (QE is the practice of buying government bonds for newly printed money, which started in 2009 and which has resulted in the BoE now holding around 40% of all UK government debt).
Predictably, this inflation of the money supply eventually led to price inflation, which started to become a problem in 2021 and now stands at a massive 10.1%. To fight that, the BoE has undertaken to reverse QE, but is yet to show any evidence that it can successfully do so. They have also begun to raise their main interest rate, which now stands at 2.25% and is set to increase further in the coming months, however, with inflation running in double digits, real interest rates are still hugely negative: investors make a lot less by buying bonds that they lose simply by prices rising. Over the years, this artificially low interest rate environment has led to some perverse decision making at the heart of our financial system, where many institutions have resorted to unprecedented risk taking, and it was the enormous and complicated risk in the pension funds in particular, which will inevitably spread to the banks (who have provided leverage to the pension funds and stand to lose out massively if these were to be unable to honour their commitments), that is the most clear and present danger to Britain’s financial stability.
The many problems in the economy now threaten to derail the recovery that has been ongoing after the lockdowns and the UK is predicted to enter a recession next year. As economic activity slows, there are certainly deflationary pressures at play, but it will take a very long time or a very deep crisis to offset the imbalances and malinvestments resulting from the past decade-and-a-half of hyper-inflationary central bank policies – and of course, it will take the BoE to remain committed to not reversing its policies of higher interest rates and quantitative tightening through all the resulting turmoil. But as we saw in the aftermath of the mini budget, that is not at all what the bank intends to do: given the choice of fighting inflation or a financial crisis, it will choose to fight a financial crisis every time.
Britain is, of course, not the only major economy to suffer from huge structural imbalances. All western economies struggle with massive government debt and deficits and are trying to extricate themselves from years of uber-accommodative monetary policy. Some, like Germany, have a much deeper problem with energy than Britain. The US runs a massive current account deficit as well, though as long as the US Dollar retains its status as the world’s reserve currency, they have more room for manoeuvre. But all these economies are doomed to failure in the long run.
For Britain, however, the end may come sooner than that. The financial markets seem unwilling to let us off the hook and we may be just one adverse event away from a crisis which the BoE can’t contain. The result could be a collapse of the Pound and a meltdown of the British financial system.