‘Kwasi didn’t Kwrash it’

Hysteria, innumeracy, and investments decisions are rarely happy bedfellows. So it was that following Kwasi Kwarteng’s mini budget, we were drowned by expert media opinion all agreeing on its fiscal “irresponsibility”. When there is apparently such a strong consensus in financial markets it is invariably wrong.

The most significant aspects of the mini-budget, notably the Energy Price Guarantee (estimated to cost £60bn over the first 6 months and £100-200bn over two years) had already been previously announced, as had the repeal of announced hikes in Corporation Tax (£16bn) and NI (£16bn), whilst the penny of the basic rate of Income Tax was brought forward a year (£5bn). The only new news was the abolition of stamp duty on transactions under £1.5m (£1.5bn) and the resumption of the 40% (£2bn) top rate of Income Tax, which had previously existed under both main political parties from 1988 to 2009 (See Fig 1: Projected UK Fiscal Deficit 2022-23¹).
New market information of tax cuts amounting to 0.2% of GDP was small beer relative to the measures we already knew about, notably the Energy Price Guarantee (which we estimate will cost £75bn or 3.5% GDP this year), but which remains highly sensitive to the cost of gas-powered electricity generation (which has since come down). Whilst it is legitimate to debate the domestic politics around the reduction in the top-rate of tax, suggesting that it is the source of fiscal instability is a symptom of financial innumeracy. 

One week later the Pound got back to pre-mini-budget levels before Kwarteng dropped the top-rate tax cut proposal because of the political instability it had caused. But the UK remains vulnerable to the same fundamental non-Kwasi factors: namely, the energy crisis and the Fed hiking cycle. Britain’s oil and gas production peaked in 1998 and since 2004, it has been a net importer of fossil fuels, now producing only half of its consumption (See Fig 2: UK Oil and Gas Production²). Unlike its EU counterparts, the new UK government has at least now set a goal of energy self-sufficiency, repealing the ban on fracking and rediscovering enthusiasm for North Sea production.

As Business Secretary, Kwarteng foolishly suggested that increased UK production would not ease the energy crisis since energy prices were set globally (even though gas prices vary considerably according to location). The Chancellor will find that exporting (or even importing less) fossil fuels at those same high global prices would do wonders for Britain’s twin fiscal and trade deficits, for the Pound and the fight against inflation. With the intermittency problems of wind still not fully appreciated blog.argonautcapital.co.uk/articles/2022/03/14/the-wind-trap-why-wind-power-has-already-peaked and nuclear development constrained by time and cost, digging for Britain to find a big dollop of readily accessible shale gas should be a matter of national emergency.

It is now incredible to think that the Federal Reserve only started to tighten monetary policy in March (with an end to QE and just a 25-basis point rate hike). The Fed hiking cycle presents a unique threat to Britain’s housing market given the amount of variable rate mortgage exposure, which constrains a hawkish Bank of England policy response. With bond market futures now pricing in a peak Fed Funds rate of 4.5% in March 2023, the Fed hiking cycle wrecking ball looks set to wreak more havoc on global financial markets and the global economy, but this is likely to be a somewhat cyclical headwind which should start to ease within six months, well before the UK’s next General Election in 2024.

Some commentators have also suggested that UK debt has a solvency risk. In fact, the UK currently has the second lowest Debt/GDP ratio in the G7, which is now expected to peak at 95% rather than 85% previously, which is still below Japan, Italy, the United States and France Unlike Italy, France, and Germany it also borrows in its own currency, which it can print (See Fig 3: G7 Debt to GDP %³). Suggesting that the UK government might default on interest payments on sterling dominated debt is for the birds.

There are parallels with the current fiscal situation in the UK to the 1970’s which Argonaut warned about last year, youtube.com/watch?v=5jW3iaoV_RA&t=7s when a similar energy crisis and hangover from easy money led to higher inflation and a decade long bear market in financial assets. As with the 1970’s the UK is currently living beyond its means, with large projected fiscal (8.6%) and current (8.5%) account deficits, that require positive international capital flows from what Denis Healey, the UK’s 1970’s Chancellor derisively termed “the Gnomes of Zurich” when they were less enthusiastic to fund his government’s spending.  It is however difficult to argue that the UK is currently under-taxed. Even after Kwarteng’s budget, tax as a proportion of national income remains at the highest level since World War Two (See Fig 4: UK Tax as % Gross National Income).⁴ 

In 1976, the Labour government sought a bailout from the IMF, requesting a $3.9bn loan. But the significance of the IMF loan was largely symbolic: the amount was small relative to the 1976 projected fiscal deficit of £12bn (then $20bn), with only half of the loan ever drawn down. Rather the IMF intervention allowed the then Labour government to sell public spending cuts to its unionized and public sector clientele. As part of the bailout terms, the IMF insisted on spending cuts and Britain reducing its high rates of marginal taxation. Tax as a proportion of gross national income is significantly higher today than the 1970’s. 

Britain’s 1970’s economic crisis was eventually resolved by the discovery and production of North Sea oil and gas, after which the UK became a net exporter and a more enthusiastic down-sizing of the state under Margaret Thatcher, following her election in 1979.  History may not repeat, but the solution to Britain’s similar economic crisis still rhymes today. 

Barry Norris
Argonaut Capital
October 2022