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| Compared to forecasting just a month ago that the UK would fall into recession this year, the IMF now forecasts a modest 0.4% growth in 2023. (Source: Shutterstock) |
A policy dilemma that will be exacerbated by broader geopolitical and economic forces.
Key challenges
The International Monetary Fund’s latest assessment of the UK economy in April 2023 contained some welcome good news. Compared to forecasting just a month ago that the UK would fall into recession this year, the IMF now forecasts a modest 0.4% growth in 2023.
But it is important to put this good news in the long term. In the short term, Britain’s economic performance is expected to remain among the lowest in the industrialised world. Inflation remains high and persistent. And in the long term, low productivity will remain a drag on growth and living standards.
Some of these short-term problems have been exacerbated by international issues, such as the conflict in Ukraine and the resulting high energy and food prices, as well as disruptions to global supply chains during the Covid-19 pandemic. Meanwhile, in the UK, despite continued net migration to the country, many businesses report that they are still unable to recruit enough skilled workers.
There are also signs that inflation has become more acute in the UK than elsewhere. Contrary to market expectations, UK core inflation rose in April. The BoE has warned that less competition from European firms is allowing UK firms to raise prices. Workers are demanding pay rises to match high inflation, adding to the pressure from labour shortages.
Finally, the measures in the “mini budget” of former Prime Minister Liz Truss’s government in autumn 2022 added further stress and uncertainty to the UK economy. The market reaction to the tax cut strategy announced in the “mini budget” was immediate and violent.
Despite the reversal of the “mini-budget” measures and further consolidation measures introduced in the March 2023 budget, public debt is forecast by the Office for Budget Responsibility (OBR) to continue rising over the next four years, underscoring the lack of fiscal space the government faces.
Policy dilemma
The UK government’s current priorities are to reduce inflation to its 2% target and to begin reducing the budget deficit and public debt. These targets are aimed at helping the economy grow faster by increasing the number of people in work. Although unemployment remains low by historical standards, this reflects a rise in the number of people not participating in the labour force and very low productivity growth.
The short-term policy dilemma is how to reduce inflation without hurting growth. The priority of the fall 2022 “mini-budget” was growth, created through tax cuts, but that effort was derailed by the negative market reaction. The priority now is to reduce inflation quickly, which means both monetary and fiscal policy will have to be tight for some time.
The long-term challenge is low labour productivity. Improving this is key to sustainable economic growth over time, but the IMF estimates that the UK's growth rate is just 1.5% a year.
The two main drivers of productivity growth are improving the quality of the workforce and increasing the quantity and quality of productive investment. But neither of these is easy to achieve, nor can it be achieved quickly.
Increasing the workforce also requires training and education, and can take years to produce results. Increasing investment could achieve faster progress, but given domestic “belt-tightening” (especially of public resources), investment may be constrained in the current environment.
A quicker route is to attract foreign capital, particularly foreign direct investment (FDI). This can also be more effective, as foreign investment often brings cutting-edge technology and increases competition, forcing domestic firms to operate more efficiently and productively.
A fragmented global environment
The UK has many attractions as an FDI destination, but Brexit makes it a less attractive option due to export restrictions to the EU.
This is one aspect of geo-economic fragmentation. The latest World Economic Outlook highlights some recent developments in multilateral trade, investment and technology. Instead, there are pressures for countries to focus more on “self-reliance” and good relations with geopolitically aligned countries, the so-called “friendship”.
Brexit, US-China trade tensions and the Russia-Ukraine conflict are examples of this trend, which is challenging international economic and political relations. More broadly, growing public discontent with globalization is encouraging more inward-looking policies.
A key example is the recent introduction of the Inflation Reduction Act (IRA) and the CHIPS and Science Act in the US, which provided over $400 billion in tax credits, grants and loans to support the domestic semiconductor industry and clean technology manufacturing.
The main goal is to counter China’s growing importance in strategic sectors such as semiconductors and electric vehicles, while attracting foreign investment and jobs. The EU is also developing its own subsidy package.
The IMF concluded that this fragmentation would lead to large output losses and negative spillover effects for the global economy, especially for countries that would suffer losses due to investment being diverted elsewhere.
The UK faces serious domestic challenges with limited scope for fiscal intervention to address them. If geo-economic fragmentation persists and intensifies, it will increasingly impact international relations, reverse globalisation and negatively impact living standards in many countries.
As an open economy, the UK is likely to be particularly affected by these forces. It may need to follow the lead of the US and EU and provide more industrial subsidies – for example to battery manufacturers – or lose out in the competition to attract and retain high-tech and clean energy industries.
With limited financial resources, that means Britain must build alliances with larger partners – including working more closely with the EU and the US on science, technology and regulatory issues – or risk losing out in a fragmented global environment.
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