anshul gupta

anshul gupta

01-10-2022

03:00

What will happen to a car with two drivers? In the UK, the two drivers are the government and the central bank, and the car is the UK's economy.

Last Friday, the UK government announced its biggest tax cuts since 1972! But the step comes at a time when the UKโ€™s inflation is at a 40-year high, and the central bank has been hiking its interest rate to control it.

So, why did the UK government come up with this package? The reason is: the country is stuck in a low-growth-high-tax spiral.

The UKโ€™s GDP grew at a low growth rate for the past 50 years. A low growth means lower government revenue, and then to make up for the lower revenue, the government needs raise taxes. A higher tax rate again leads to lower economic growth.

The UK is stuck in this spiral and the newly elected Truss government wants to break it by lowering the tax rate.

The issue with this? The tax cuts will reduce the government revenue and, thus, increase the deficit (Expenditure - Revenue). The higher the deficit, the more the UK government would need to borrow.

Thus, it needs to issue more bonds to finance the deficits. And if supply of bonds increases, the cost of borrowing (yields) for the government also increases.

Just to put the impact into perspective, the UK needs to pay more interest on a 5-year bond than Italy or Greece after the tax cut announcement. The investors are showing more faith in these debt-ridden nations than in the 6th largest economy!

And while the government is giving tax cuts to encourage spending, the central bank has hiked its interest rate to a 14-year high trying to discourage spending. The goal is to get inflation under control.

Higher rates mean a higher incentive to save and more expensive to borrow - resulting in less spending by people and firms. Thus there will be less demand for products - which means lower inflation.

For whatโ€™s happening in the UK, the only precedent is the US in the 1980s, where US president Ronald Reagan followed an expansionary policy to increase the overall economic demand, and the US central bank lowered the money supply to battle inflation.

The policy received a mixed response. The debt tripled in 10 years but also led to a higher growth rate. The question is: Can the UK replicate this success? The pound says no.

The USA could handle the situation because the dollar is the global reserve currency. $ strength kept the import cost low, and as imports were low, deficits were also down.

But the pound has touched the lowest level since 1985, and itโ€™s just a few cents away from attaining parity with the US dollar. A falling pound makes imports more expensive, adding to inflation.

On the one hand, the fiscal policy is giving energy subsidies to people, and on the other hand, the monetary policy is raising their interest burden.

When the government and central bank are not aligned, the economy and markets both suffer. Even the IMF has asked the government to re-evaluate the tax cuts. Do you feel this will work out for the UK?



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