By Paul Krugman of The New York Times
Financial markets usually give wealthy, politically stable nations a lot of fiscal space. In particular, a country like the United States, 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.
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’re British) happened over the past week, when Liz Truss, the new prime minister of the United Kingdom, announced a neo-Reaganite “fiscal event.” (She didn’t 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 — basically her Treasury secretary — 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 rising, the pound plunged.
This wasn’t the market reaction you’d 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 wasn’t 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 wasn’t 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’ve 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.
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 don’t 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 didn’t 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 U.S. 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’s still too soon to write Britain off; it’s 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.