Financial markets usually give wealthy, politically stable nations a lot of
fiscal space. In particular, a country like the US, or for that matter Britain,
can normally run quite big budget deficits without creating a run on its
currency. This is because investors typically believe that nations like ours
will, in the end, get their acts together and pay their bills; they also
believe that central banks like the Federal Reserve and the Bank of England
will do whatever it takes to prevent deficit spending from setting off runaway
inflation.
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In fact, deficit spending in an advanced economy
normally causes the value of that country’s currency in terms of other
currencies to rise, because the collision between fiscal stimulus and tight
money leads to high interest rates, and these high rates attract an inflow of
capital from abroad. When Ronald Reagan cut taxes while increasing military
spending during the early 1980s, the dollar surged against other major
currencies, like Germany’s Deutsche mark (this was long before the creation of
the euro).
But a funny thing (or not so funny, if you are
British) happened over the past week, when Liz Truss, the new prime minister of
the United Kingdom, announced a neo-Reaganite “fiscal event”. (She did not call
it a proper budget, because that would have required issuing fiscal and
economic projections, which probably would have been embarrassing.)
It was already clear that the Truss government was
going to have to increase spending in the short run, to aid families hit with
higher energy bills stemming from Russian President Vladimir Putin’s de facto
natural gas embargo. Rather than raising taxes to help cover this expense,
however, Truss’ chancellor of the Exchequer announced tax cuts, notably a big
reduction in taxes on the highest earners.
The parallel with Reaganomics was obvious. Interest
rates duly rose. But in this case, rather than rise, the pound plunged.
This was not the market reaction you would expect
for an advanced economy. It was, instead, similar to what you often see in
emerging markets, where investors worry that governments will cover increased
deficits by printing more money, causing inflation to accelerate.
Now, such things have happened in Britain before.
Back in 1976, Britain experienced a sterling crisis, in which concerns about
budget deficits caused a plunging pound, adding to already-high inflation.
Humiliatingly, the government was forced to turn to the International Monetary
Fund for a loan, which came on the condition that the government make deep cuts
in public spending.
At the time, however, the Bank of England was not
the independent institution it later became. It was, in effect, just a branch
of Her Majesty’s Treasury, and it accommodated the inflationary effect of
deficits rather than acting to offset them. These days, the bank is not only
independent, but it also has a mandate to keep inflation low.
So why the sudden run on the pound? One answer I
liked came from City of London economist Dario Perkins, who declared that the
problem with the budget was not that it was inflationary, but that it was
“moronic”, and that an economy run by morons has to pay a risk premium.
But while I like the idea of a “moron” premium,
there may also be a more concrete concern. I have been in correspondence with
other City of London economists, and they have expressed doubts about whether
the bank will actually be willing to tighten enough to offset the inflationary
impact of Trussonomics.
It is still too soon to write Britain off; it is a rich country with a lot of freedom to maneuver. On the other hand, if British monetary policy really is constrained in this way, going all in for zombie fiscal policy is even more irresponsible than it would be otherwise.
These doubts were reinforced Monday, when the bank
disappointed investors hoping for an emergency rate hike to stabilize the
pound, limiting itself instead to a rather vague statement that it “would not
hesitate” to raise rates if necessary to limit inflation.
Yet I do not see any reason to believe that
Britain’s central bank has lost its political independence or that it will
allow itself to be bullied into avoiding rate hikes by a government that
apparently believes in the zombie idea that tax cuts will pay for themselves.
There may, however, be a Britain-specific reason the
Bank of England might be hesitant to raise rates sufficiently to contain
inflation.
The more I look at current events in Britain, the
more I find myself harking back not to 1976 but to the other sterling crisis of
1992. At the time, while the euro did not yet exist, many European nations,
Britain included, were part of a system intended to keep the relative value of
their currencies stable — a so-called exchange rate mechanism. In 1992-93,
however, the European ERM came under severe pressure from speculators, most famously
George Soros, who began betting that many of Europe’s economies would give up
on their targets and allow their currencies to fall against the Deutsche mark.
Defending against this speculative onslaught would
have required sharply raising interest rates for an extended period. And in the
end, several countries, Britain included, proved unwilling to do that.
Why? Part of the answer was that Britain was
suffering from high unemployment at the time and feared that rate hikes would
deepen its slump. But there was another, perhaps even more pressing, concern.
For a variety of reasons, British homeowners, unlike their US counterparts,
tend to have either floating rate mortgages, whose interest rates vary with the
market, or mortgages that will come due and need to be refinanced within a few
years.
In 1992, this meant that defending the pound with
higher interest rates would quickly translate into direct financial pain for
millions. And after a few weeks of defiant rhetoric, policymakers caved to the
pressure and let the pound fall.
I have no direct evidence that similar
considerations are weighing on the Bank of England now. But it seems likely.
It is still too soon to write Britain off; it is a rich
country with a lot of freedom to maneuver. On the other hand, if British
monetary policy really is constrained in this way, going all in for zombie
fiscal policy is even more irresponsible than it would be otherwise. And you do
have to wonder how long Truss will last, given this huge unforced policy error.
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