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| Compared to a forecast just a month ago that the UK would fall into recession this year, the IMF now forecasts a modest growth rate of 0.4% in 2023. (Source: Shutterstock) |
A policy dilemma will be exacerbated by broader geoeconomic and geopolitical forces.
Key challenges
The latest assessment of the UK economy by the International Monetary Fund (IMF) in April 2023 contains some welcome good news. Compared to a forecast just a month earlier that the UK would fall into recession this year, the IMF now forecasts a modest growth rate of 0.4% in 2023.
But it's important to consider this good news in the long term. In the short term, the UK's economic performance is still considered among the lowest of industrialized countries. Inflation remains high and persistent. And in the long term, low productivity will continue to be 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 its resulting rise in energy and food prices, as well as disruptions to global supply chains during the Covid-19 pandemic. Meanwhile, in the UK, despite a continued increase in net migration into the country, many businesses report that they are still unable to recruit enough skilled workers.
There are also signs that inflation has become more severe in the UK than elsewhere. Contrary to market expectations, UK core inflation rose in April. The Bank of England has warned that less competition from European companies is allowing British companies to raise prices. Workers are demanding wage increases to match the high inflation, exacerbating the growing pressure from labor shortages.
Ultimately, the measures in former Prime Minister Liz Truss's "mini-budget" in the autumn of 2022 added further strain and instability to the British economy. The market reaction to the tax cuts announced in the "mini-budget" was immediate and violent.
Despite the reversal of “small budget” measures and further consolidation measures introduced in the March 2023 budget, public debt is projected by the UK Office for Budget Responsibility (OBR) to continue rising over the next four years, highlighting the limited fiscal space the government faces.
Policy dilemma
The UK government's current priorities are to bring inflation down to a target of 2% and begin reducing the budget deficit and public debt. These goals aim to help the economy grow faster by increasing employment. While the unemployment rate remains low by historical standards, this reflects an increase in the number of people not participating in the labor force and very low productivity growth.
The short-term policy dilemma is how to reduce inflation without harming growth. The priority of the "small budget" in the fall of 2022 was growth, generated through tax cuts, but this effort was derailed by a negative market reaction. The current priority is to quickly reduce inflation, which means both monetary and fiscal policies will have to be tightened for a period of time.
The long-term challenge is low labor productivity. Improving this is key to sustainable economic growth over time, but the IMF estimates the UK's growth rate at only 1.5% per 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 they be attained quickly.
Strengthening the workforce also requires time for training and education, and it can take years to yield results. Increased investment can achieve faster progress, but due to domestic austerity measures (especially with public resources), investment may be limited under current circumstances.
A faster path is to attract foreign capital, especially foreign direct investment (FDI). This can also be more effective, as foreign investment often brings the most advanced technology and enhances competition, encouraging domestic businesses to operate more efficiently and productively.
A fragmented global environment
The UK has many attractive points as a destination for FDI, but its departure from the EU ( Brexit) has made it a less attractive option due to export restrictions to the EU.
This is one aspect of geoeconomic fragmentation. The latest World Economic Outlook report highlights several recent events related to multilateral trade, investment, and technology. Instead, there are pressures on countries to focus more on "self-reliance" and good relations with geopolitically linked nations, the so-called "friendships."
Brexit, trade tensions between the US and China, and the Russia-Ukraine conflict are examples of this trend, posing challenges to international economic and political relations. More broadly, growing public dissatisfaction 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 U.S., providing over $400 billion in tax credits, subsidies, 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 significant losses in output and negative spillover effects on the global economy, particularly for countries harmed by the relocation of investment.
The UK faces serious domestic challenges with limited scope for using financial interventions to address them. If geoeconomic fragmentation persists and intensifies, it will increasingly impact international relations, reverse globalization, and negatively affect the living standards of many countries.
As an open economy, the UK is particularly vulnerable to 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 the competition to attract and retain high-tech and clean energy industries.
With limited financial resources, the UK must build alliances with larger partners – including closer cooperation with the EU and the US on science, technology, and regulation – or risk losing ground in an increasingly fragmented global environment.
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