Lack of coordination between monetary and fiscal policy is hurting the UK economy and threatening a global currency crisis. What might that mean for NZ?
Comment: UK Prime Minister Liz Truss’ economic plans have thrown the UK market into turmoil and briefly triggered the pound’s biggest ever drop against the US dollar this week. Should New Zealand be worried about the flow-on effect?
Truss and the UK Chancellor, Kwasi Kwarteng, are being urged to reverse their tax-cutting plans, introduced in a fiscal statement by Kwarteng to Parliament last week.
Following the statement, the Treasury published The Growth Plan 2022, but investors simply did not buy the economic plans of large tax cuts funded by steep increases in government borrowing, leaving the British pound in freefall.
The Bank of England has now stepped in with temporary purchases of long-dated UK government bonds to restore orderly market conditions, saying it “stands ready to restore market functioning and reduce any risks from contagion to credit conditions for UK households and businesses”.
Two points I emphasised in my previous article were the importance of the right monetary-fiscal policy mix and the management of public expectations. The new UK government failed in both aspects.
The UK economy has many problems. It contracted in the second quarter of 2022, falling by 0.1 percent compared with the previous quarter. It comes after gross domestic product (GDP) expanded by 0.8 percent in the first quarter of the year.
The cost of living has been increasing in many countries since 2021 and the UK is no exception. The consumer price index (CPI) rose by 10.1 percent in the 12 months to July 2022, before falling slightly to 9.9 percent in August.
Bank of England Governor Andrew Bailey said in his letter to the Chancellor that the bank expects a peak just below 11 percent in October.
When inflation rises, central banks intervene and raise interest rates to slow the economy and reduce inflation. The Bank of England raised its main interest rate from 1 percent to 1.25 percent in June. In August it raised it again, by 50 basis points, taking it to 1.75 percent. At its meeting ending on September 21, 2022, its Monetary Policy Committee voted to increase it to 2.25 percent.
Fiscal policy is pulling in the opposite direction. The announced economic plan is being recognised as an inconsistent choice in an inflationary environment. Tax cuts and additional borrowing will increase demand, creating more inflationary pressures. In offsetting, we will see further increases in interest rates.
More reliance on inflows of foreign money
The UK’s current account deficit was 1.2 percent of GDP in the last quarter of 2021. It deteriorated to a record 8.3 percent of GDP in the first quarter of this year, as the country’s imports far exceeded the value of its exports.
Any deficit must be funded, and foreign investment is essential to finance the current account deficit. UK business and consumer confidence are dropping, and capital inflows will fall with decreasing confidence levels.
If the government fails in inducing a proper economic environment, this deficit will be unsustainable.
Will tax cuts produce stronger economic growth? How about inequality?
Under the previous government’s plans, the rate of corporation tax was to increase from 19 percent to 25 percent from April 2023 for firms making more than £250,000 profit, around 10 percent of actively trading companies.
The Growth Plan 2022 tells us the new government has committed to cancel the increase in the main rate of corporation tax, keeping it at 19 percent.
Do corporate tax cuts boost economic growth?
Empirical findings vary considerably. Some studies report positive growth effects of corporate tax cuts, while some others find significantly negative or insignificant effects.
A recent European study provides a quantitative analysis of the existing econometric literature. Using a data set consisting of 441 relevant estimates from 42 primary studies, this research finds the average effect of corporate tax cuts on growth is zero, with some variance for individual cases. Also, it is found that corporate tax cuts tend to be even less growth friendly when considering a short time horizon.
Meanwhile, a new report assessing the implications of Kwarteng’s fiscal statement says the highest-income households are the biggest winners from the Chancellor’s changes to personal taxation. The report discusses two-thirds of the gains from the personal tax cuts confirmed at the fiscal statement go to the richest one-fifth of households, while just 12 percent of the gains will go to the poorest half of households.
A 2022 study by researchers from King’s College London, which uses data from 18 OECD countries from 1965 to 2015, finds tax cuts for the rich lead to higher income inequality in both the short- and medium-term. On average, each major tax cut results in a rise of over 0.7 percentage points in top 1 percent share of pre-tax national income. Regarding the economic growth, the study finds such reforms do not have any significant effect on growth.
Should we be worried in NZ?
The British pound is not alone in its drop against the US dollar, against which several other currencies have been declining. With aggressive interest rate hikes by the US Federal Reserve, 'money' is going back to the US as the safest choice.
Are we seeing any impacts of this in New Zealand? The value of the NZ dollar against the US has fallen, dropping to its lowest value against its US equivalent since March 2020. China’s yuan is at its weakest since the global financial crisis, hitting a record low offshore.
Is the situation in the UK going to cause a global currency crisis? Noted American economist Paul Krugman says that given the UK accounts for less than 3.5 percent of global GDP, the answer is no. Harvard economics expert Professor Lawrence Summers, on the other hand, says a currency crisis in a reserve currency could well have global consequences. One thing that is very clear is that high volatility in currency markets is going to be with us for a while.
The annual current account deficit continues to widen in New Zealand. In the year ended June 30, 2022, the annual current account deficit was 7.7 percent of GDP, which is just below the highest ever deficit-to-GDP of 7.8 per cent recorded in December 2008. This is something to watch over next few quarters.
The worst-case scenario would be a global recession via synchronised interest rate increases. The Federal Reserve’s aggressive interest rate hiking seems set to continue. Central banks in other countries, including New Zealand and Australia, will keep pushing the interest rates in this case to maintain the value of their currencies. This will translate as less investment, fewer jobs, low growth, and higher unemployment. Social costs will be higher for many everyday Kiwis.
What we have learned since last week is that making the management of expectations - maintaining the confidence of economic agents, households and businesses - and coordinating the fiscal and monetary policy is a crucial part of economic policy.
I hope policymakers everywhere are learning through this experience.
