It is not impossible that the U.K. may be the first heavily indebted Western country to enter a fully fledged financial crisis.
It is not impossible that the U.K. may be the first heavily indebted Western country to enter a fully fledged financial crisis (this time around).
As I explained in a Capital Letter in February:
Thanks to Covid, the financial crisis, and government by a Conservative party that had swung towards Merkelism, Labour inherited a country where the debt/GDP ratio stood at 100 percent and the state had swollen. Real wages had been stagnant since 2008, and real per capita GDP has not fared much better. The tax burden was the heaviest it has been in seven decades and the budget deficit was somewhat over 4 percent.
Labour looked at this legacy and decided to make it worse, increasing taxes, regulation, spending, and borrowing.
For their part, financial markets have been looking at what Labour has been doing and have not been impressed. And Britain’s economic outlook has deteriorated further since February, not helped by the government’s continuing extravagance, the fact that some of its tax increases have (surprise!) backfired, and the catastrophe that is its determination to speed up Britain’s “race” to net zero. In a nutshell, Labour’s sums don’t add up.
There was a brief market panic earlier in the year, dangerous territory for the U.K., which typically has around 25–30 percent of its government bonds (“gilts”) held by foreign investors, who have no overriding reason to have gilts as part of their holdings. That means that they have no overriding reason to hang on to their positions in British government debt in the event of any sign of serious trouble.
It is no secret that there are severe tensions within the government over some of the (inadequate) cost-cutting promoted by Rachel Reeves, Britain’s distinctly underwhelming chancellor of the exchequer (finance minister). Accordingly, eyebrows and interest rates shot up when a visibly distraught Reeves shed a tear in the House of Commons on Wednesday. This was put down to a “personal matter.” If that’s so, she deserves only sympathy. Even if the cause was political, she also deserves sympathy, but investors can be forgiven some unease. Reeves is known to have been upset by an altercation with the speaker of the house (over her conduct in the Commons), but it is generally accepted that that was not to blame. A more likely culprit is the way that the prime minister, Keir Starmer, has recently reined in her spending cuts. Just how acrimonious have the discussions between him and Reeves really been?
Rachel Reeves triggered a £3 billion market sell-off on Wednesday after crying at Prime Minister’s Questions. The Chancellor was seen wiping away tears as Sir Keir Starmer raised doubts about her future by failing to confirm that she would stay in her role.
The scenes triggered higher UK borrowing costs, with the effective interest rate on 10-year government debt experiencing one of the biggest jumps since Liz Truss was prime minister. The pound also fell, and ended the day down almost 1 per cent against the US dollar.
Ms Reeves’s show of emotion came the day after a welfare package designed to save the Treasury £4.5 billion a year was gutted, making it more likely she will need to raise taxes later this year. . . .
The scenes triggered panic in the markets and warnings that the jump in borrowing costs — if sustained until the autumn — would knock £3 billion off the Chancellor’s wafer-thin £9.9 billion buffer to balance the books.
Alex Kerr, of Capital Economics, suggested that another tax raid was on the way. He said: “Combined with the about-turns on welfare spending and winter fuel payments, which will cost around £6 billion, that leaves the Chancellor’s headroom pretty much wiped out at just under £1 billion.
The next morning, Starmer came out with strong words of support for Reeves. She would be “the Chancellor for a very long time to come.” Markets recovered, but this should not be read as a vote of confidence in Labour’s management of the economy. Investors simply believe that, given the survival of the current government, which has a large majority and no need to call an election for four years, the alternatives would be even worse. They probably would.
Starmer’s endorsement of Reeves may do the trick for now, but that won’t change the fact that, unless Britain abandons the economics of the madhouse, there is going to be a market panic that really will end in tears.