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17 November 2022

Rishi Sunak can’t blame financial markets for his spending cuts

Investors panicked by the reckless mini-Budget won’t be happy when the Autumn Statement’s austerity weakens growth either.

By Emma Haslett

On 27 October, two days after Rishi Sunak was appointed Prime Minister, a familiar face returned to Downing Street: George Osborne, the former chancellor, was invited back to advise Sunak’s Chancellor, Jeremy Hunt.

Osborne is the architect of austerity, the Conservative belt-tightening strategy that helped the party to win the general election in 2010. In an effort to aid the UK’s recovery from the financial crisis and “balance the books”, Osborne slashed spending and imposed draconian pay freezes on the public sector.

Austerity was, for a time, reasonably effective, but we’re still seeing the repercussions now. Figures published on Tuesday 15 November showed a 42 per cent rise in the number of 25- to 34-year-olds dropping out of the labour market since 2019 thanks to long-term sickness – a consequence of real-terms cuts to NHS spending during the austerity years. And it’s worth questioning whether the strategy ever actually worked. Since 2010 net debt has actually risen, from 64.5 per cent of GDP to 96.6 per cent, according to the Office for National Statistics. Even before the pandemic it was higher, at 79.5 per cent.

In today’s Budget, Hunt and Sunak are likely to re-introduce the policy to plug a so-called fiscal black hole, caused partly by the pandemic and partly by Brexit, which was then exacerbated by Liz Truss and Kwasi Kwarteng’s disastrous mini-Budget. “The government I lead will not leave the next generation, your children and grandchildren, with a debt to settle that we were too weak to pay ourselves,” Sunak said in his first speech as Prime Minister.

The mini-Budget, which included £45bn of unfunded tax cuts, was a botched attempt to tackle the UK’s problem of low growth. Sunak and Hunt are opting for a different tactic: addressing inflation, which is at 11.1 per cent, a 41-year high. By stating that he wanted to cut debt, Sunak was saying that he had seen the markets’ reaction to the mini-Budget, when yields on long-dated government borrowing climbed above 5 per cent for the first time in 20 years, making that borrowing much more expensive, and had heard the message loud and clear: inflation must be brought down. Cutting spending means wage growth will slow, unemployment will rise and inflation will fall to more acceptable levels.

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But has Sunak interpreted the markets’ message correctly? Quite apart from the fact that the fiscal black hole is a product of rules imposed by the Conservatives, and that no one can really agree how big it is (estimates range between £50bn and £70bn), there’s also a risk: that too much austerity will cause the recession predicted to last for the whole of next year to be longer or deeper (or both).

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[See also: The Tories are trapped with no good options]

The UK suffered from low growth long before inflation reared its ugly head. Average annual GDP growth since the financial crash in 2008 has been 1 per cent. Austerity is a sure-fire way to weaken it further, says Janet Mui, head of market analysis at RBC Brewin Dolphin, and this won’t go down well with investors. “Money markets want growth,” she says. “They want to see the UK manage its finances, but not to the extent that everybody’s not spending. It’s a very fine balance.”

Giles Coghlan, chief market analyst at the broker HYCM, adds: “[The government has] got to bring down inflation, balance their books, but they can’t do it at such a pace that they totally crush their growth and bring about a big restriction in the economy.”

Sunak’s commitment to austerity also ignores the fact that the markets’ reaction to the mini-Budget was not just about what was announced, but how it was announced, says Coghlan. Before the mini-Budget was even presented, markets were becoming nervous as Truss “was making some quite outlandish statements about changing the Bank of England’s mandate, about maybe addressing the way that we look at assessing inflation,” he says.

The frenzied reaction after the mini-Budget was more rational than it appeared. “Bond markets said, ‘gosh, if you want to do that, that’s fine – but we’re going to position ourselves financially prudently, to allow for that’,” says Coghlan. “It was the financial markets saying, ‘if this is the direction the UK economy is heading then we need to position ourselves to allow for an inflation-stoking environment’. The bond market reacted the way it did because undergirding it all was just a lack of competence of what is being planned.”

In 2010 the UK was suffering from low growth. This time around we are beset by high inflation, too. While Truss’s mini-Budget addressed the former problem, Sunak and Hunt have chosen to address the latter. Neither administration has presented a good way to address both. If Sunak and Hunt go too far the other way, investors may anticipate even lower growth and start to pull out of the UK. “You need the wisdom of Solomon to get it right,” admits Coghlan. “I don’t envy anyone having to make these decisions”

[See also: Jeremy Hunt’s Autumn Statement was a George Osborne tribute]