Number Theory: Understanding why Rishi Sunak’s job is unenviable
The fact that it took a crisis of confidence in the economic wisdom of his predecessor Liz Truss to put Sunak in the prime minister’s position, means that economic policy will be an important determinant of his stint in office.
UK’s newly appointed Prime Minister Rishi Sunak was the Chancellor of the Exchequer (UK’s equivalent of the finance minister) for a little over two years from February 2020 to July 2022. The fact that it took a crisis of confidence in the economic wisdom of his predecessor Liz Truss to put Sunak in the prime minister’s position, means that economic policy will be an important determinant of his stint in office. This should ideally give Sunak some comparative advantage to begin with. However, an HT analysis shows that it is not going to be an easy task for the new prime minister. Here are four charts which explain this in detail.
Truss’s botched tax cut plan spooked not just markets but even IMF
On September 23, Truss’s Chancellor of Exchequer Kwasi Kwarteng announced UK’s biggest tax cuts in 50 years, which included a reduction in income tax rates on the highest income bracket. A report published in The Guardian estimated that these announcements would lead to a tax write-off of 45-billion-pound sterling, more than 6% of the total tax collection in UK in 2021-22. Given uncertainties over how the tax cut was to be financed – the government’s defence was that it would boost long-term growth – bond markets reacted violently. 10-year nominal yields on British government securities increased from 3% in the beginning of September to 4.6% on October 10, the highest they have been since the 2008 global financial crisis. “At the height of the chaos, Britain’s five-year borrowing costs were higher than those of Italy and Greece, two countries that have had difficult relationships with their lenders”, The Economist wrote in its issue dated October 22-28.
The tax cuts were so drastic that even IMF asked for them to be reconsidered. “The proposal was likely to increase inequality and add to pressures pushing up prices”, the BBC reported summarising the IMF’s observations.
Scrapping tax-cuts and the change in leadership have calmed markets but challenges remain
Under fire from financial markets and multilateral bodies, not to mention the Labour Party’s opposition to the tax cuts, Liz Truss had to first sack her Chancellor of the Exchequer and then quit office herself, eventually paving way for Sunak to take over as the Prime Minister. While these developments have arrested the trajectory of rising bond yields and falling exchange rate of the Sterling, Britain’s economy continues to face critical challenges. A raging inflation is the biggest problem at the moment. The Consumer Prices Index including owner occupiers’ housing costs (CPIH) grew at 8.8% on an annual basis in September 2022, 5.9 percentage points higher than what it was a year ago. The inflationary surge, along with a pushback from unions, who are demanding higher wages to meet the increased cost of living, is threatening to trigger a prolonged vicious circle of wage-price spiral in the British economy.
Efforts to control inflation could harm already muted growth prospects
To be sure, Britain’s economic prospects were not looking very bright even before Liz Truss announced her ill-fated tax cuts. UK’s economy had a compound annual growth rate (CAGR) of 2.9% between 1980 and 1990. This came down significantly even before the pandemic, and forced a 9.2% contraction in 2020. Growth projections from IMF’s World Economic Outlook (WEO) database show that UK’s post-pandemic recovery is likely to be extremely muted until 2024.
If IMF’s projections hold, CAGR of GDP growth between 2019 and 2027 (the latest period for which GDP projections are available) will be the worst since the 1980s. While IMF’s projections are likely to have taken into account the effect of interest rate hikes, a doubling down on this front will only hurt growth prospects even more. The official bank rate in England has increased from 0.1% in November 2021 to 2.25% until now, which is bound to have led to a significant increase in debt servicing costs of both firms and households.
Prudent economics might not be clever politics for Sunak
What will complicate matters even more for the new Prime Minister is the fact that economic policies which might calm markets and improve government finances -- these could include more interest rate hikes and cuts in government spending -- might not necessarily appeal to the Conservative Party’s voter base. A 2019 YouGov survey on the British elections shows that the Conservative Party had a bigger lead over its main rival Labour Party among voters with lower educational levels (who are also more likely to be poor). This means that any aggressive austerity plans are likely to hurt what is a more important constituency for Sunak’s party. To be sure, an October 21 YouGov poll shows that 65% of those surveyed expect Labour to form the next government -- a clear indication of support for the party across various sections.