Truss-oh no-mics
What is going on in Britain?
“What is going on in Britain"?” is always a puzzling question - the monarchy, the cuisine, the bizarre incompetence in sports they invented. But right now the British pound is tumbling, British bonds are crashing, and the stock market is reeling - posing the question of “why”.
The British government recently announced a “mini budget” of policies designed to counteract the various economic issues facing Britain. It would stand to reason there is at least some relationship between the announced policies and the subsequent collapse of the British currency - unless you believe that this is all a woke capital strike by politically correct banks to impose gender ideology on the UK, which poses the question of why you are reading this piece to begin with.
A brief summary
We do not have to appease the voices of decline. The same old economic managerialism has left us with a stagnating economy and anaemic growth, with labour productivity growing at just 0.4 per cent a year since the financial crisis. Taxes are now at their highest in 70 years. This toxic combination needs to be urgently addressed.
For the past decade, the British economy has performed underwhelmingly - with low growth, low productivity, and all around bad vibes. Currently, Britain is going through a “cost of living crisis” - a large increase in energy bills, grocery prices, and housing costs. Part of the issue is the general rise in inflation, but it should be noted that inflation increased in Europe to a much greater extent due to energy prices than to excess demand, given that core inflation has run much higher in the States while headline inflation was similarly high between the two entities.
The UK government, therefore, has decided to take the opportunity to tackle both issues at the same time by announcing a playbook for more investment, more productivity, and more growth. The announced policies were:
Cuts in income taxes for both all individuals and specifically for top earners
Cancellation of an announced corporate tax increase
Price cap on energy bills
Changes to taxes and planning rules for housing and commercial uses
Tightening job requirements for welfare programs
Cuts to taxes on property purchases
Cuts in the taxes paid to fund the NHS specifically
Looking into setting up “investment zones” in England
Scrapping a cap on bonuses paid to bankers
Some changes in regulations to investment
Ideally, the solution to the problems facing Britain would be primarily supply-focused: more energy, more housing, etc. The Truss government’s playbook, however, is pretty different: the “mini budget” subsidizes demand and does little, if anything, for supply. Supply-wise, the announced changes are pretty underwhelming: the most effective-looking policies are the changes to housing law (which has been so bad for so long that the Blitz was economically beneficial) and to investment. So not increasing supply and raising demand - a recipe for more inflation.
Given that the financial markets reacted very poorly to the news, it would seem that they expect bad outcomes: no surge in growth, more inflation, and higher deficits. The problem is that there are three key facts that can’t be accounted for simultaneously.
Sherlock Holmes for monetarism
Initially, it appears that the markets expect higher inflation: the exchange rate represents the ratio between the price levels of two countries, which means that the pound crashing seems to imply that the financial market expects prices to grow more quickly, resulting in a weaker currency and, through the Fisher Effect, on higher nominal interest rates - real interest rates would be the same, but nominal rates would be higher because of higher inflation. However, inflation breakevens (the expected inflation rate implied by financial transactions) aren’t any higher, so the pound falling and interest rates surging cannot be accounted for higher inflation expectations - because expectations didn’t go anywhere!
An alternative is that the markets expect the Bank of England (the UK’s central bank) to overreact to the increase in inflation and provoke a severe recession - which accounts for the higher rates (which would be higher real rates, since policy would be tighter) and for the constant breakevens (inflation would be under control eventually). A small hitch is that, if the market expected a serious monetary policy induced recession, then the pound would appreciate, not devalue - since it would have lower inflation than its trade partners after the fact.
Thirdly, the markets could be buying into Truss’s ideas and believe the new government will revitalize the economy - which accounts for the steady breakevens and for the higher interest rates (as a stronger economy is often accompanied by higher nominal and real rates, for a variety of reasons). The issue is that, once again, a stronger economy would also have a stronger currency - and the pound is weaker!
Lastly, another possible story is that the markets are concerned with His Majesty’s Treasury becoming increasingly irresponsible with its financial situation, but the Bank of England reigning in the excess demand - resulting in a weaker currency, higher borrowing costs, and no change in expectations. Nonetheless, credit default swaps (a measure of the chance a government defaults) haven’t gone up, so it’s not likely that the UK government is expected to be extremely irresponsible.
It’s all about trade
This section on the Balance of Payments is fairly superficial; I’ve gone in more detail on a previous post about the collapse of the Russian ruble earlier in 2022.
It’s reasonable that the markets believe the new announced policies will increase inflation, and that they will be offset by the Bank of England - accounting for some of the change in financial conditions. But I think that a very underrated driver of the changes in Britain’s monetary standing have nothing to do with taxes, productivity, or banker’s bonuses - and everything to do with the announced cap on energy bills.
By capping households’ energy expenditures, the UK government is de facto committing to importing as much oil and gas as it takes to meet more demand under the same prices - i.e., to importing more and, ceteris paribus, to widening the trade deficit. If Britain is to have a larger deficit, and if there are no policies to increase productivity (which would allow for more exports), then the only option is to let the currency lose value. This is due to the fact that the Bank of England has comparatively low reserves (about 80bn, which is lower than most Latin American economies) and therefore cannot even remotely credibly commit to freezing the pound at its higher level and paying out the difference between imports and exports.
Given that imports are rising and exports are falling, and there’s no change in the reserve position, the balance of payments must adjust somehow. A country’s balance of payments has three components:
the current account: exports of goods and services, plus transfers into the country
the capital account: weird stuff like sports players transactions or loan forgiveness
the financial account: investment, lending, and borrowing
Given that nobody is expecting Britain to just sell off all of its soccer stars to pay for oil, and that they’re not plugging the gap with remittances, the bigger current account deficit will have to be paid for with a bigger financial account surplus. Weirdly, borrowing counts as positive in the balance of payments (since cash is coming in), so the UK will either have to borrow the difference, or it will have to promote foreign investment into the country.
Because swaps are steady, it’s not likely that the expectation is that the Treasury or the BoE will borrow the difference - the risk of default, naturally, goes up the more you owe. And since, as mentioned above, the supply-side agenda announced so far is paltry at best, then the difference has to come through “financial investment”, i.e. the kind of capital flows that Latin American countries used to try to attract to balance out their atrocious trade policies and overvalued exchange rates. And you wouldn’t guess the easiest way to get these capital flows into your country: higher interest rates.
All in all, a slightly higher expected inflation rate and a much higher trade deficit, to be plugged in by short-term capital flows, seem to account for the plunge in value of the British pound, the collapse in bond prices and equivalent rise in interest rates, and the lack of movements in market inflation expectations or anticipated default risk.
This appears to be yet another example of Liz Truss trying to copy Thatcher’s worst ideas: looser fiscal policy and tigher monetary policy is not a sustainable mix at reducing inflation, a lesson to be learned from the UK’s self-declared arch rival.