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Baba’s Explainer – U.K.’s Economic Crisis

  • IASbaba
  • October 18, 2022
  • 0
Economics, International Relations
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Syllabus

  • GS-II- International Event
  • GS-III- Economy

Context: Recently, British Prime Minister Liz Truss fired Chancellor of the Exchequer (chief finance minister of UK) and dropped parts of their economic package that had been previously announced to tackle increasing inflation and sooth market turbulence.

When did the trouble begin?
  • The U.K. economy has veered dangerously toward free fall in recent weeks as the government led by Ms Truss fumbled its way through defining a clear economic strategy, while persisting with their stated goal of spurring economic growth in the post-Brexit scenario.
  • Their troubles began shortly after September 6 when Ms. Truss took over from her predecessor, Boris Johnson, who resigned as Prime Minister after an internal party rebellion over his involvement in the “party-gate” scandal.
  • At the time she vowed to make the Conservative Party respectable and electable again. Yet even as she entered office, her Cabinet stared at a looming energy crisis partly driven by the instability caused from energy supply disruptions associated with Russia’s Ukraine war.
  • While she appeared to act decisively in early September to assure British families of an energy price guarantee and subsequent cost savings, it was her broader plan to cut income tax for the highest earners in the U.K. and to scrap a corporate tax hike that has attracted criticism.
    • The first policy that the Truss-Kwarteng duo came up with to kick-start the U.K. economy was a plan to abolish the 45% top rate of income tax for people on incomes of £1,50,000 or higher.
    • A second policy in a similar vein was the proposal to scrap a planned increase in corporate tax from 19% to 25% starting next April.
  • The government also said the government would borrow at least 60 billion pounds to finance a plan to cap high energy prices for households and businesses that have triggered a cost-of-living crisis.
  • The government’s goal is to boost economic growth to an average of 2.5% annually, which it says will increase tax revenue and provide more money for public services.
Why have these proposals been unpopular?
  • Underfunded Tax Cuts: The two tax relief measures announced for highest earners amounted to £45 billion in unfunded tax cuts. The government’s action has primarily been criticised for slashing revenue sources without adequately funding the large fiscal gap that such a give-away would create.
  • Misplaced Priority: The recent proposals have also been attacked as the wrong priority given the more immediate concern surrounding inflationary trends triggered by global commodity price fluctuations and the supply side constraints of a post-Brexit economic structure.
  • Unsustainable debt: The government didn’t provide any independent analysis of whether the government’s goal was likely to be achieved or its impact on public finances. That triggered speculation that the government would have to finance the package with borrowing, pushing public debt to unsustainable levels.
  • Clashing with BoE attempts to rein in Inflation: In addition, the government’s decision to pump billions into the economy is likely to fuel further price increases, meaning the Bank of England (BoE) may need to raise interest rates even higher to control inflation that is already running at a near 40-year high of 9.9%.
  • Increased Bond Yields indicating loss of investor Confidence: After the announcement, the yields on 10-year government bonds jumped dramatically, from 3.5% to 4.3% and then settled at nearly 4.05%. It is broadly agreed that a rise in government bond yields, effectively the cost of borrowing to the U.K. government, indicates a lack of confidence in the market to purchase the government’s debt
    • Investor confidence has taken a downturn likely in the belief that it has ballooned out of control or that sufficient mitigation measures are not in place to bring such debt back to sustainable levels.
    • The cost of borrowing has continued to rise despite the Truss government’s U-turn on its two controversial tax policies.
What are the political ramifications of the crisis?
  • There is a common perception that the Truss government may not have long to go due to its poor economic policymaking. Most likely that Ms. Truss could be ousted from office before the next general election, which is set to happen by January 2025 or sooner.
  • Rumours are abound that Ms. Truss may be ousted out of Prime Ministership by Christmas 2022, and installing in her stead a “moderate dream ticket” comprising Mr. Sunak and Penny Mordaunt, who has served as Minister and Secretary of State under Mr. Johnson and Margaret Thatcher respectively.
  • Both members are acknowledged to be Conservative Party heavyweights and challengers to Ms. Truss in the recent leadership contest.
What steps would be required to mitigate the crisis?
  • Financial markets are likely to remain volatile until the government releases its full economic plan, including the independent analysis of the impact on public finances.
  • While the Truss government’s U-turn on the unfunded tax cuts may temporarily calm the turmoil in markets and prevent further economic damage, deeper macroeconomic changes are required to bring the U.K. back to a stable path of economic growth and manageable inflation levels.
  • The executive must refrain from undermining the Bank of England’s (BoE) attempts to get a handle on inflation, now nearly 10% in the U.K.
    • The BoE has been attempting to do so through a series of interest rate hikes aimed at moderating business and consumer spending.
    • An unfunded fiscal programme with knock-on effects on the cost of borrowing and government bond prices limits the ability of the BoE.
  • Investors are looking for assurances that the government is committed to reducing debt as a percentage of gross domestic product once Britain gets past the current economic crisis.
  • On public expenditure, what might be required in the long term to develop the U.K. economy that can face the challenges of the 21st century is a more visionary public investment programme similar to the European Union’s trillion-dollar climate and digitalisation scheme or the U.S.’s expansive climate and infrastructure programme.

Main Practice Question: What lessons can India learn from UK Economic crisis?

Note: Write answer his question in the comment section.


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