Experts: UK Financial Turmoil Could Be Contagious; Pandemic Is Root Cause

Fiscal, monetary policies at odds

Chancellor of the Exchequer Kwasi Kwarteng (L) and Britain's Prime Minister Liz Truss watch a tribute to Queen Elizabeth II on the opening day of the annual Conservative Party conference in Birmingham, England, on Oct. 2, 2022. Leon Neal/Getty Images

Financial turmoil hit Britain and sent shock waves through the global financial market, just weeks after Britain’s new prime minister Liz Truss took office.

On Sept. 23, Britain’s Chancellor of the Exchequer, Kwasi Kwarteng, announced the country’s most radical package of tax cuts in nearly 50 years, calling it a “new era” for the British economy. The package included a cut to the top rate of income tax for high-income earners and cuts to income tax and stamp duty on home ownership.

“We need a new approach for a new era, focused on growth,” Kwarteng said.

Immediately after the announcement, GBP/USD tumbled and fell all the way to 1.0327, an all-time low.

In the days that followed, Gilts—British government bonds—fell sharply, triggering unprecedented margin calls for fixed-income funds, including many pension funds. Pension funds sold both government bonds and investment-grade corporate bonds to raise money, causing bond prices to fall further.

On Sept. 29, the Bank of England announced that it would buy about 65 billion pounds ($69 billion) of long-term UK government bonds, as it tried to restore order to the markets. The bank said the tax cut plan had led to a sharp fall in UK asset prices that, if left unchecked, could weaken the country’s financial system and economy.

Experts’ Analysis of the British Economy

The passing of the Queen, the Russia–Ukraine conflict, the energy crisis, and high inflation have all had a strong negative impact on the UK’s economic growth, according to Mike Sun, an investment advisor based in North America.

“In the face of the worsening economic situation, the British government has taken a risky move by introducing an extreme tax cut stimulus plan,” Sun told The Epoch Times.

“For fiscal stimulus policy to work, there must be a full treasury. However, the British government is currently facing a ‘shortage of ammunition’ dilemma. The tax cut will further widen the fiscal gap, which will need to be covered by the issuance of national bonds.”

U.S.-based economist Davy Jun Huang believes that Truss’s drastic reforms, taking place against a background of global hyperinflation and interest rate hikes, stand in sharp contrast to tightening economic policies in Europe and the United States.

“The market and economists believe that aggressive easing in the UK will lead to a large increase in the fiscal deficit at a time when mainstream economies are tightening their finances,” Huang told The Epoch Times.

“The pandemic aid, tax cuts, and fiscal laxity of previous years have led to high fiscal debt. Plus the strong dollar and the Russian-Ukrainian war crisis, there will be significant outflows of hot money from the UK, exacerbating [its] already high inflation.”

“These factors will inevitably make the market believe that there is less gold in sterling,” Huang continued. “Coupled with a strong dollar and uncertainty about the new prime minister’s aggressive reform—the likelihood of a recession is increasing significantly— the pound fell to a record low, and treasury bonds also sold off, sparking fears of a British financial crisis.”

Frank Tian Xie, a professor at the University of South Carolina’s Aiken School of Business, speculated that Parliament could investigate Kwarteng ’s actions and Truss could ask for his resignation, even though she is not opposed to the policy.”

“It is obvious that the Truss government also favors tax cuts to get Britain out of trouble, but the coverage and details of the policy seem ill-conceived and need further deliberation,” Xie told The Epoch Times.

“However, with the overall economic situation in the UK deteriorating so much, the government’s inefficiency and lack of tacit understanding in operation will undermine investor confidence, further exacerbate market chaos, and directly affect European financial markets.”

UK Financial Turmoil a Global Wake-Up Call

Britain’s financial turmoil comes as a wake-up call when countries are experiencing inflation and central banks are aggressively raising interest rates.

The UK is the world’s sixth-largest economy, London is the second-largest international financial center and sterling is one of the most actively traded currencies worldwide.

Therefore, the financial market turmoil in the UK has had a huge impact on global financial markets, particularly because the world’s major economies are mired in the worst inflation of the 21st century, Jun Huang said.

“The United States, the largest economy, has raised interest rates sharply ... which has led to the spread of fear of economic recession; China, the second largest economy, has slowed down its economic growth significantly and is still insisting on the ‘zero-COVID’ policy; and the Russia–Ukraine war brings human beings closest to a nuclear crisis in this century,” he said.

“The ill-timed financial turmoil in the UK has caused ‘contagious fears’ to spread internationally and could further lead to a ‘parallel sell-off in global capital markets.”

ICE BofA Move index, which tracks the volatility of U.S. Treasury expectations, has reached its highest level since March 2020, indicating that the $24 trillion U.S. Treasury market is facing its most severe round of turbulence since the outbreak of COVID-19.

The Fear & Greed Index, a technical indicator used by traders to gauge the strength of willingness to buy and sell the pound, is at its lowest level since the first wave of the COVID-19 crisis.

Global ratings agency Moody’s has put a “negative” assessment on the UK tax cuts, arguing that such a move would damage the UK’s credibility with investors. S&P Global Rating has gone further, cutting its outlook on Britain from stable to negative on Sept. 30. If fiscal strains persist, the UK’s sovereign credit rating could be downgraded.

Pandemic Is Root Cause of Global Market Woes

Huang believes that the contradiction between the UK’s interest rate tightening and the large-scale tax cut is actually a contradiction between monetary policy—set by the central banks and involving interest rates and the supply of money in circulation—and fiscal policy, namely the government’s tax and spending decisions.  Likewise, it represents a contradiction between suppressing inflation and safeguarding employment and the economy.

“It’s a contradiction that most of the world’s major economies may not be able to avoid, given that the world is currently in the midst of historically high inflation,” he said.

The World Bank reported on Sept. 15 that the risk of a global recession had increased.

“The world may be edging toward a global recession in 2023 and a string of financial crises in emerging market and developing economies that would do them lasting harm,” reads the statement.

Huang argues that COVID-19 was ultimately the source of this global inflation. The spreading virus caused factories to shut down, economies to stagnate, unemployment to rise, and supply chains to break, while forcing governments to use the largest quantitative easing in the history of the human economy.

“The fiscal policy contradiction facing the UK may not escape other countries,” he said. “Excessive quantitative easing during the pandemic was just trading time for space to postpone the economic crisis.”