Two months after the 2024 election I wrote an article – “Is Labour Already Sowing the Seeds of Another Economic Crisis?”- which predicted that Labour’s term of office would end with a currency crisis. Immediately after the Budget I also warned that the UK economy was heading for recession. As a forecaster (but not a citizen) it is gratifying to get the direction of travel right when being way more pessimistic than the consensus, but economic prospects are worsening even faster than I expected. Recent data indicates that the economy is already in recession – mainly caused by the Budget’s damaging tax increases – which implies the OBR’s fiscal projections are way off target. In normal circumstances a weakening economy, accompanied by sustained low money supply growth, would mean the Bank of England could aggressively cut interest rates. However, the Bank is constrained from doing so by the recent rise in inflation and by higher bond yields – primarily caused by the Budget’s £140bn increase in government borrowing.
The Bank’s dilemma has been made worse by a recent alarming deterioration in the UK’s underlying balance of payments position. My fears of a currency crisis may be proved right much sooner than I thought. The UK has run a current account deficit every year since 1984, and since 1999 these deficits have ranged between 2% and 6% of GDP (except for 2021, when the deficit was only 0.4%*), relying on large net foreign borrowing to finance the gap. The consequence has been a drastic erosion of our international investment position from what was a large surplus of foreign assets over liabilities to a large deficit of over $ 1 trillion (£837bn) or 30% of GDP by Q3 2024. The OBR forecasts current account deficits will continue at present levels for the whole of its five-year forecasting horizon. How long can this go on? President Nixon’s key economic adviser, Herbert Stein, famously opined that
“If something cannot go on forever it will stop” and applied this logic to sustained balance of payments deficits by arguing that
“If such a process is limited by external factors, there is no urgency for government intervention to stop it, much less make it stop immediately, but it will stop of its own accord”
There is no economic model that can tell us when “it will stop of its own accord”. However, the IMF uses a concept called the “basic balance” to analyse the underlying strength of a country’s balance of payments. Apologies to the reader for diverting into arcane economics, but the implications are crucial. Simplifying somewhat, for a deficit country the basic balance takes the current account deficit and adjusts it by the country’s net long term capital flows. So, if a country has a current account deficit of 2% of GDP but net long term capital inflows of 2% of GDP then the basic balance is zero. Nothing to worry about there. Conversely, if that same country has net long term capital outflows of 2% then the basic balance is a deficit of 4% of GDP. Much more concerning, because that country is then dependent on short term capital inflows of 4% of GDP to finance the deficit. Short term capital is a more volatile and less dependable source of borrowing than long term capital, which consists primarily of direct investment in factories, buildings etc and portfolio investment in bonds and equities.
It is in the UK’s basic balance that the recent deterioration has occurred. In the four quarters to the end of September 2024 (the latest data) the UK’s basic balance ran at a deficit of 8% of GDP! Roughly speaking a current account deficit of 2.5% of GDP was accompanied by net long term capital outflows of 5.5% of GDP – with large net outflows of both direct and portfolio investments. We have suddenly become extremely reliant on short term capital. In Q3 2024 alone the basic balance was running at an annual rate of around 10% of GDP, while the net international investment deficit widened by a further £104bn.
In this situation significant cuts in Bank Rate risk setting off a major slide in the currency and a rise in bond yields. UK policymakers and the commentariat focus on the fiscal deficit, and the two issues are strongly linked, but our greatest vulnerability lies in the external accounts. You may be sure that global hedge funds are on high alert to profit from this. If a crisis occurs the Left will point fingers at “speculators” rather than themselves, but this would be like complaining about the vultures who clean up the African savannah.
Lord Agnew, a former Tory Treasury minister assigned to oversee Whitehall efficiency who resigned in frustration at his government’s failure to control spending said the following in a recent interview:
“Already the public markets are saying, ‘You’re on suicide watch, we’re watching you carefully’. My own view is that we will face an IMF moment of 1976. There will be a point at which the public debt markets do not believe the narrative that this country can continue to borrow money and use it as ineffectively as we are using it”.
Ironically, Labour’s election manifesto made restoring economic growth it’s “number one objective”. Faster economic growth will raise tax revenues, reduce welfare spending, cut the fiscal deficit and attract rather than repel long term capital. However, Labour in office have shown neither the understanding nor the political will to achieve this goal. More ironically still, they have a rough template** of how to do it from their nemesis across the Atlantic. The USA also has large current account deficits and a bigger fiscal deficit than the UK. However, in addition to the “exorbitant privilege” (the view of President De Gaulle) of possessing the world’s reserve currency the US now has a credible plan to promote sustained economic growth: cut business taxes, cut government spending and the bureaucracy, aggressively deregulate, boost oil and gas production, and abandon net zero. Labour must urgently reverse course and implement a similar programme, adjusted for our own circumstances and political constraints. If we don’t, the contrast between our economic performance and that of the USA will just increase investor focus on our vulnerabilities.
How likely is it that Labour will change course, and to what degree is it feasible for them to do so? On the positive side it seems that Starmer and Reeves recognise change is needed. Reeves is to present a Bill to Parliament making it easier to overcome planning and regulatory obstacles – including unnecessary environmental rules – to housing construction and infrastructure development. Concessions on non-dom tax reforms have been made and attempts underway to cut current unprotected public spending by 5%. Reeves was mocked for consulting regulatory bodies on how to boost economic growth, but since they are responsible for growth blocking regulations it is not a nonsense to confront them. She has fired the previous head of the Competition and Markets Authority for not sufficiently backing the growth agenda. Reeves and the PM have even begun to speak positively about how Brexit enables the UK to regulate better, notably on financial services and AI. One aspect of the Trump programme that we rightly won’t follow is tariff protectionism, and Starmer now claims to be open to an FTA with the US. In the meantime, we must prioritise completing the advanced FTA negotiations we have with India, the Gulf Council, Switzerland, S. Korea and others. Starmer’s referral to Trump of the appalling Chagos deal, while a humiliation, at least means that the deal will probably not go ahead.
The key issue is net zero. Current net zero policies will significantly widen our current account deficit and weaken economic growth even further. Imports will increase due to drastic reductions in our N. Sea oil and gas output, buying of electricity from Europe due to growing reliance on intermittent renewables, and lower domestic food production due to a massive expansion of the electricity grid and solar panel ‘farms’ – both of which will require large scale imports of equipment. Exports will decline as key export industries – notably autos and chemicals – become increasingly uncompetitive due to our world high electricity prices. Leading UK industrialist Jim Ratcliffe recently said that:
“We are witnessing the extinction of one of our major industries as chemical manufacture has the life squeezed out of it…..De-industrialising Britain achieves nothing for the environment and merely shifts emissions, businesses and jobs elsewhere”
There is a direct correlation between electricity prices and use of “renewables” – the higher the percentage of electricity that comes from wind and solar the higher are electricity prices***. The Chancellor has started to challenge the Energy Secretary by pushing for a third runway at Heathrow, and expansion at other airports. The Chancellor has been heavily criticised (including in this parish) for her many early mistakes, but she is showing courage in starting to change course and confront her party with reality. If Miliband remains in office there can be no prospect of the growth agenda succeeding. The transition to net zero needs to be governed by market forces and not unrealistic government targets and diktats. This would require changes to the Climate Change Act which it is difficult to conceive a Labour government contemplating even ex-Miliband. The Scottish judge’s recent decision to block production on the two large N. Sea fields under development may be the final death blow for any hopes of reviving domestic production of oil and gas and yet another reason for capital to flee the country.
It seems very likely then that Labour’s change of course will be too little too late to avert a major crisis of confidence, most probably centred around the currency. Such a crisis will probably lead to a major split in the Labour Party between pragmatists and ideologues. In that circumstance the Tory Party should be ready in the national interest to support the pragmatists if they propose the radical market-based reforms, more realistic net zero policies and public spending cuts that will then be required to restore stability.
Robert Lee Feb 1st, 2025
*The current account deficit fell sharply from 5.4% of GDP in 2016 to within spitting distance of a surplus in 2021, primarily due to rapid growth in services exports, so our current account difficulties can in no way be pinned on Brexit. They are the consequence of poor policy choices that have led us to “live beyond our means” for decades. Remainers please note!
**Astonishingly, the recently retired Cabinet Secretary and head of the Civil Service, Simon Case, recently wrote that the Trump agenda could be a template for future UK reforms to reduce the size of the bureaucracy, improve its efficiency, cut public spending and improve regulation. Who knew?!
***According to the International Energy Agency the average electricity cost in a country with little or no solar and wind power is about 10p per kWh. For every 10 percentage points of additional solar and wind, the cost increases by more than 4p. The UK has the biggest percentage – about 40% on average – of its electricity supply provided by solar and wind of any developed economy, and the highest electricity prices. And Mr Miliband is hell bent on increasing it to 95% by 2030…..
