It is time for the UK to think like an emerging market

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The writer is president of the Peterson Institute for International Economics and a former member of the Bank of England’s Monetary Policy Committee

Calling the UK an emerging market became an intermittent investor epithet during its recent economic and political turmoil. The serious point of such a characterisation is that the macroeconomic regime has shifted. Britain never adjusted sufficiently to the flatlining of productivity growth since 2008. Brexit then intensified issues and the UK faces real miseries. Though credit flows have not come to a sudden stop, and are unlikely to do so, policymakers should now act as though they are under a self-imposed IMF stabilisation programme.

Unlike the largest economies, there is now less room for policy error, and fewer good choices, when negative shocks hit. Hence the need to put a solid floor under the situation, forestalling further descent. A co-ordinated programme would not require sharp fiscal austerity, and certainly should not include irresponsible tax cuts, mortgage bailouts or industrial policy white elephants. It does require a multiyear plan, the redistribution of economic burdens and a decrease in inflation.

Some false debates should be put aside. Brexit did not cause all of the UK’s economic problems, but it made almost all of them worse. Real shocks, some global, were much of the initial source of inflation, but this has turned into trend inflation. Net macroeconomic tightening is necessary, and higher interest rates are not inflationary. For household incomes to catch up, money has to be taken from somewhere else.

Accepting those realities, a UK stabilisation programme should have six components. First, a major reallocation of fiscal priorities. A significant wage increase — but less than the full amount of inflation — should be given to the NHS, education, first responders, and some transport workers over the next two years, along with much lower increases thereafter. This should be paid for by taxes on high-income workers and capital gains, as well as on property.

Similarly, public investment in the energy grid, mass transit, and critical infrastructure should be increased, while cutting other subsidies and programmes. This is not permission for the UK to join the self-defeating subsidies race between the US, EU, and China.

Yes, all this will be dismissed as completely politically impossible. A country with five governments in seven years, let alone one facing a general election, is unlikely to sustain such commitments. Yet, that is exactly what small unstable economies face when they get into IMF programmes. Such commitments are what restores credibility. The UK has the luxury of doing this on its own terms, when things are merely miserable but not an outright crisis.

Second, calls for aid for mortgage holders need to be largely ignored. There are few unfairnesses greater than the fact that property owners get all the benefits of real estate price booms and low interest rates, but demand bailouts, often successfully, when rates rise and prices fall. In a stabilisation, hard choices have to be made. Let property prices fall, which is disinflationary, and force any restructuring of mortgages to come out of the private sector lenders, not the public budget.

Third, pursue the long talked about planning reforms to spark a boom in construction. Making housing more affordable and widely available while promoting domestic employment should be a no-brainer. Crucially, this has to be about deregulation and promoting increased supply, not about making it easier to buy.

Fourth, actually carry through the obvious labour supply reforms to address the clear mismatch between available workers and jobs, and the decline in labour force participation. As UK economists have pointed out, the meanness of benefits mean there is a terrible disincentive to be unemployed versus in employment or on disability benefits; there is also insufficient investment in the health and retraining of workers.

Fifth, lean in to being a global Britain post-Brexit. Think like a small country and specialise, rather than unsuccessfully following larger ones. So, do even more of the pro-immigration policy which has been the one major source of growth of late, and double-down on attracting foreign students. Do not subsidise manufacturing, but attract R&D and use of business services. Do join CPTPP (as the UK is doing) and other pacts, and put pressure on the US, EU, and China to open up more broadly, instead of trying to cut bilateral deals at a bargaining disadvantage.

Finally, monetary policy has to tighten quite a bit more. It never made any sense for the Bank of England to keep saying they were about to reach their terminal rate, while the Federal Reserve and the European Central Bank both said they had to keep raising, when the UK had both the US’s labour market problems (or worse), the eurozone’s gas price spikes (or worse), and is smaller than either. The inflation forecast since late 2021 should have been higher and longer. Even the latest rate rise by the BoE was couched in terms of more may or may not be needed. More is needed and the bank should say so clearly.

This plan may seem politically far-fetched. There is a reason why economies often need an external force to impose a programme before anything gets done. For all its economic miseries, the UK is not on an exchange rate peg, is not facing capital flight, and interest rates on long-term gilts could rise a lot more without inducing a crisis. Yet its economy is distinctly similar to an emerging market under pressure, which means stabilisation is the credible path forward. The present muddling through, leaving the path to disinflation uncertain, will just make things worse.