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UK Macroeconomic turmoil

Summary:
This is my second post on the recent troubles with Sterling. In the first, I discussed vibes, mood, and animal spirits. I do think that is the best way to think about what’s going on, but I promised to write as an economist typically do (not as we all our in this case). The basic facts are that Chancellor Kwasi Kwarteng announced a mini-budget revision including elimination of the 45% income tax bracket. Oddly many financiers who would directly benefit were alarmed. The Pound depreciated to under .04 (before recovering) and the 10 year Gilt rate increased by over 1% (before recovering). There are two economic questions. The first is why a very large policy shift had such a sudden rather huge effect. The second is why the pound depreciated.

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This is my second post on the recent troubles with Sterling. In the first, I discussed vibes, mood, and animal spirits. I do think that is the best way to think about what’s going on, but I promised to write as an economist typically do (not as we all our in this case).

The basic facts are that Chancellor Kwasi Kwarteng announced a mini-budget revision including elimination of the 45% income tax bracket. Oddly many financiers who would directly benefit were alarmed. The Pound depreciated to under $1.04 (before recovering) and the 10 year Gilt rate increased by over 1% (before recovering).

There are two economic questions. The first is why a very large policy shift had such a sudden rather huge effect. The second is why the pound depreciated. The unprovoked tax cuts are similar to the Reagan tax cuts and the dollar then appreciated (causing huge trade deficits and deindustrialization). Why did the pound move the other way.

As usual I start by reading Krugman and you would be better off reading him than me.

Basically one possible explanation is that investors fear that the bank of England will monetize the debt causing high inflation (that is they fear fiscal dominance). This was not an issue in the USA in the 1980s because Paul Volcker was very tough and Presidents can’t change the law easily. A law declared the Bank of England to be independent, but it is very easy for UK Prime Ministers to change laws (back bench revolts are often discussed, but rarely happen, but this might be the time).

There are two reasons (aside from the UK elective monarchy and the facts that Truss and Kwarteng seem to be nuts) for the suspicion that the UK long term Gilts might be risky. One, noted by Matt Yglesias somewhere, is that the FIscal authority has also made an open ended spending promise — they promised to protect firms and consumers from high energy prices. If this were a binding commitment, it would be a liability which can’t be inflated away, as energy prices are set in world markets and not fixed in pounds sterling. I don’t the the amount is large enough. Also it wasn’t a legally binding commitment. I think this is another large (not huge) deal. Unclear commitments to spending increases clearly add to the effects of specifically announced tax cuts, but it isn’t huge. This could even imply some risk that his majesties Treasury will default again (“Braveheart” is set at the last time it did). Investors do not seem to fear that — I don’t have the link, but UK Gilt credit default swaps remain cheap.

The other, stressed by Krugman, is that the Treasury is not the only debtor at risk if there are high interest rates. Most UK mortgages have variable interest rates and others are short term and have to be refinanced soon. This (along with the absurd house prices) means that mortgagers might default if there are high interest rates. Also they will be very angry and they are Tories.

So there are reasons to doubt the Bank of England’s willingness (or ability) to fight inflation with extremely tight monetary policy in response to the fiscal folly.

The Bank did not act as it would have it the problem were lack of anti-inflation credibility. The Bank promised to buy bonds on ‘Whatever Scale Is Necessary’ to “restore orderly market conditions”. A central bank buying however many bonds it has to buy to keep interest rates low is also called fiscal domminance. Importantly bond yields fell after the announcement. The issue is not just or mainly suspected wetness at the bank.

Also note “orderly” . The problem was not just the increase in yields, there were also another sign of a financial crisis – low trading volume so long term Gilts lost liquidity. This is what happened with residential mortgage backed securities in 2008. This happens if no one wants to buy except at firesale prices, but the bond owners don’t want to book huge losses selling them cheap – unless they have to. In turn it happens if some might have too — if there is a risk of fire sales as entities desperate for liquidity sell at a very low price.

In the UK the entities are pension funds. Another difference between the US and the UK is that many English people still have defined benefit pensions (in addition to their stingy public pensions). This means that pension funds can go broke because their assets lose value. Importantly, money can be withdrawn (paying a penalty of course). There can be a run on some UK defined benefit pension plans.

This means that the fear of gilts is a fear of fear itself. Fund managers fear that ordinary people will lose confidence in long term treasuries and demand cash. They feel the need to increase their holdings of highly liquid highly safe short term gilts. Hence the disorder.

This is a case in which the Central Bank (effectively acting as a lender of last resort) can have a huge impoact (think QE1 in the USA or, especially European Central Bank President Mario Draghi saying “whatever it takes” to stop contagion of the Greek fiscal crisis).

Importantly it has been standard practice since the 19th Century and is not fiscal dominance at all. It seems possible to me that the dramatic of the Tax cut announcement and of the Babk of England’s intervention both relate to the vulnerability of defined benefit pension plans to runs.

Robert Waldmann
Robert J. Waldmann is a Professor of Economics at Univeristy of Rome “Tor Vergata” and received his PhD in Economics from Harvard University. Robert runs his personal blog and is an active contributor to Angrybear.

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