Britain is bringing back austerity. Here’s why

By Julia Horowitz, CNN Business

The last time a British finance minister revealed tax and spending plans, markets went haywire and the country’s prime minister ultimately lost her job. The new government is not looking for a repeat performance.

On Thursday, Chancellor Jeremy Hunt is due to unveil a budget that will aim to restore confidence in the United Kingdom’s ability to manage its public finances. But that may be easier said than done.

The country is staring down the barrel of a grueling recession, and investors remain on edge as interest rates rise. That requires Hunt, who has acknowledged that Britain faces “extremely difficult” decisions, to pull off a delicate balancing act.

Media reports indicate that the government is looking to come up with between £50 billion ($59 billion) and £60 billion ($70 billion) through a mix of tax increases and spending cuts, many of which may not take effect until after the next election in 2024.

“If you do too much, too soon, you risk worsening the recession,” said Ben Zaranko, a senior research economist at the Institute for Fiscal Studies. “If you delay everything until after the next election, you risk not being seen as credible.”

A new wave of austerity could help restore the government’s reputation with financial markets after the budget from former Prime Minister Liz Truss — which featured an unorthodox combination of major tax cuts and ramped-up borrowing — unleashed panic.

But it will do little to ease fears about the country’s grim economic prospects. The United Kingdom is one of two G7 economies to have contracted in the third quarter. It’s now smaller than it was before the coronavirus pandemic. The Bank of England is forecasting a lengthy recession, which could stretch into 2024.

New cuts could make matters worse. When the government adopted an austerity program in 2010 on the heels of the Great Recession, it shaved 1% off the country’s GDP, according to the UK budget watchdog. Just four years ago, former Prime Minister Theresa May pledged to bring nearly a decade of austerity to a close.

Now, tax rises could further depress consumer confidence — already near a record low — and spending cuts risk placing further strain on public services that are already buckling under enormous pressure.

Still, Hunt intends to show he has a plan to reduce government debt as a proportion of GDP in the medium-term. It currently stands at 98%. The Office for Budget Responsibility said in July that it could reach nearly 320% in 50 years.

“We do have to do some tax rises, do some spending cuts, if we’re going to show we’re a country that pays our way,” Hunt told Sky News on Sunday.

How did the United Kingdom get here? There’s no shortage of finger pointing.

Part of the problem is global in nature. Interest rates have risen rapidly around the world as central banks attempt to rein in inflation. That’s pushed up borrowing costs for the government, dealing a shock after years in which money was cheap.

At the same time, skyrocketing energy costs, exacerbated by Russia’s war in Ukraine, have compelled governments to step in to cushion the blow of crippling energy bills — shortly after they spent significant sums helping households and businesses through the pandemic.

Hunt has scrapped plans to cap energy bills for typical households at £2,500 ($2,981) for the next two years. Instead, support will only be guaranteed until next spring. But the measures will still prove costly.

The government can’t blame all its problems on the rest of the world, however.

“You can just look at how the UK is performing relative to every other country in Europe, and it’s obvious there’s a UK-specific element to this,” Zaranko said.

The Brexit effect

The United Kingdom’s exit from the European Union has weighed on trade and exacerbated shortages of workers in key industries. It has also contributed to a devaluation of the pound — down about 20% against the US dollar since the Brexit vote in 2016 — that’s helped fuel inflation by pushing up the price of imports.

“The UK economy as a whole has been permanently damaged by Brexit,” former Bank of England official Michael Saunders told Bloomberg TV this week. “If we hadn’t had Brexit, we probably wouldn’t be talking about an austerity budget this week. The need for tax rises, spending cuts wouldn’t be there.”

And while inflation in the United States cooled more than expected in October, falling to 7.7%, it’s still rising sharply in the United Kingdom, reaching a 41-year high of 11.1% last month.

That’s bolstering expectations that the Bank of England will need to keep raising interest rates and could hold them higher for longer, though recession may complicate those forecasts.

The country’s labor market also remains extremely tight, with an employment rate lower than before the coronavirus hit and a record number of people who aren’t working due to long-term illness.

“The UK does stand out in that labor supply has been very constrained, perhaps more so than in other countries,” said Ruth Gregory, senior UK economist at Capital Economics.

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