Expert explains: UK financial crisis and global economic outlook


The turmoil in the UK economy continues, with the pound falling and markets boiling. On Sunday, British Prime Minister Liz Truss announced she would double down on her economic plan, the unveiling of which on September 23 caused much of the commotion.

Udit Misra talks with Columbia University history professor Adam Tooze about market chaos and more.

First of all, could you tell us exactly what led to the current financial crisis in the UK? The mini budget was introduced and all of a sudden the UK currency, bond yields, it all came together.

I think the backdrop is deeper. This dates back to the Brexit decision in 2016. So there was a referendum in which a narrow majority of the population led by the right wing of the Conservative Party chose to leave the EU. And it was a decision taken in the face of all serious economic opinion in the world, the IMF, European leaders, the vast majority of British economists, bankers, the American president – ​​everyone.

And in a sense, since that moment, we’ve been waiting for the shoe to drop. We waited for the markets to punish an irresponsible, nationalistic, somehow willful (government). It is not fair to say that they are populists. The current generation of conservatives is not populist in the simple sense of the word. They are actually pro-business in their minds. They believe they are on a crusade to rid Britain of regulation and cut taxes to increase incentives, but they ignore market sensitivities. And what worries the markets is that they have adopted, one after the other, a gigantic law to stabilize energy prices.

So the other immediate factor operating here is that Europe, as a result of Russia’s war on Ukraine and the tensions in global gas markets around the world, which were already evident in 2021, is suffering of an epic energy crisis. At times, gas prices have been the equivalent of a thousand dollars a barrel of oil.

So really extraordinary prizes, and the government passed a package almost immediately after taking office a few weeks ago. (The package is) Valued at £150bn, that’s about 5% of GDP. Then they announced a budget, and in the budget they announced an additional £45 billion in tax cuts in the form of simple giveaways – not investments, not targeted. Just literally freebies to the overwhelming majority of the wealthiest Britons. Surprisingly enough — given that the markets are teeming with people benefiting from the tax cut — the markets panicked. Because all of a sudden they feel that this government just knows no borders.

Now government advocates will say they expect the Bank of England to raise the interest rate and that is part of the plan and then in due course, in a few weeks in November, the government will present a program to reduce expenditure in order to balance the government (budget).

All markets are basically reporting that they don’t like this program; it doesn’t make sense to them. Spending does not seem well targeted. There is no reason to believe that it will ensure faster growth.

It’s sort of the idea on the supply side that you cut taxes and in due time you’ll produce so much growth that tax revenues will go up. The whole thing has a kind of 1980s Reagan-type feel. And that includes the fact that you’re harboring, so to speak, an open and expansive fiscal policy with a tight monetary policy because that’s what America did In the 1980’s.

So it was their idea, but they didn’t go there right away. They don’t communicate that to the markets and the markets don’t buy it because it’s really not a program. It will not accelerate British growth. So what you’re basically saying is that you’re going to increase the debt burden significantly without accelerating growth.

Even in a calm market, you therefore expect interest rates to go up to stabilize things. What actually started to unfold was something much more panicky – that people are trying to pull out of all UK assets. So the exchange rate started falling, which is normally something you see in advanced economies, but it’s a sudden storm, an emerging market type spiral. So that freaked people out.

And then there are a bunch of really technical factors operating in the UK Treasury (gilt) market.

The famous British government debt market dates back to the 17th century, in which pension funds are very heavily invested in long-term government debt because that’s the type of debt you need if you want to pay pensions on 20 or 30 years old. from now on. And rising interest rates are good for pension investors in general, helping them with their long-term strategies.

But many of these pension funds had hedged against the prospect of rising interest rates to hedge against any particular type of interest movement. And the sudden adjustment in interest rates alone was enough to unwind these hedging strategies and force pension funds to hedge; they were then asked for more collateral on those transactions and then they had to start selling and what they sold was what they considered to be the most stable type of asset, which was gilt.

And then it started to produce a really toxic spiral because when people start selling in that panicky way, you get a fire sell that spreads throughout the market. So much so that at the beginning of the week, the Bank of England decided that the financial stability (of the United Kingdom) was threatened. This essentially means that the house of cards that is the financial system has begun to disintegrate. Any financial system is always a fragile pyramid. We can build it very, very high but it’s built on trust and a series of interlocking expectations, and those have started to disintegrate. And that is why we are in the situation in which we find ourselves.

Recently, India overtook the UK as the fifth largest economy. But the data also shows that between 2007 (global financial crisis) and today, UK GDP has stagnated. What causes this?

The problems of the British economy are serious. And they are historic – like never before in modern British history have we seen a period of such low growth and such low productivity growth.

I think there are a variety of different factors at play. The first is that the financial sector was a large part of the UK economy during the relatively rapid growth phase of the 1990s and early 2000s and that the financial crisis of 2008 hit the city of London extremely hard, eliminating this engine of growth.

Beyond that, there is then a chronic problem of under-investment. Thus, Britain has one of the lowest shares of investment in GDP of any wealthy economy in the world – around 15-16%. That’s far too low to generate really rapid growth.

And then the third element is Brexit, which compounds this problem. It will generate inefficiencies that will cost GDP and provide little incentive for investment. You add up these three things. You add a few other lingering issues – inequality and inadequate training, for example, and a reduction in the flow of migrants into the UK economy, which was boosting UK growth in the 1990s and 2000s – and it’s a pretty picture dark all around.

Globally, due to supply bottlenecks following the war in Ukraine, there has been much talk of either a recession or broader stagflation. What is the biggest concern?

I think there are three possibilities: crisis, recession and stagflation. And we might see all three with different variances depending on what part of the world you’re primarily in. Sri Lanka has already experienced an existential crisis. Or Pakistan. So as interest rates rise, which is the global driver of recessionary pressure, the weakest links in the global credit chain will break.

And the more defended you are, the larger your foreign currency reserves, the less dollar debt you have, the more resilient you will be to this. Because we are currently witnessing the most dispersed and comprehensive increase in interest rates that we have ever seen in the history of the global economy. It’s not the fastest increase. It was the late 1970s, early 1980s, but virtually every central bank in the world except Japan and China is actually raising rates. And that compresses, and those effects then branch out. So you get side effects from each individual central bank, raising their rates.

So the question really is: do we end up with a recession or do we end up with stagflation? The difference would be that with stagflation it would seem that we are obtaining a slowdown in growth without succeeding in countering inflation. With a recession, one would expect inflation to come down fairly quickly because the main driver of ending inflation will be increased unemployment and less steam in the economy.

So I think that’s the tradeoff. In the short term, we are going to have stagflation. In the short term, what we are going to see is a dramatic slowdown in growth and we are going to see inflation almost everywhere in the world above 5%, which is well above the average of the last decades. And so that would qualify for stagflation. When the Chinese economy slows to 2 or 3% and the overall growth rate of the world is around 2, 3 or 4% and we have inflation above 5%, that will be our modern definition of stagflation. .

I think there is a risk of recession because the pressure on interest rates that is being applied is getting stronger and stronger, it is now increasing quite rapidly. And that’s partly because prices are proving to be recalcitrant and not slowing down as quickly as many of us had hoped. I continue to believe that this will be a transitory inflationary push.

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