OK, we need to talk about the pound, which despite what you might have heard has not
been pegged to the stablecoin Tether.
The UK has been facing a cost-of-living crisis, which was a problem before the war in Ukraine,
and has only gotten worse since – in particular due to the huge spike in energy prices.
The new British prime minister Liz Truss (who assumed office a few weeks ago), has promised
to be bold and to do things differently.
Upon her appointment, she put in place an Energy Price Guarantee to limit the amount
that suppliers can charge customers for gas and electricity.
The plan is that the average British family will save £1,000 a year based on current
energy prices.
A thousand pounds converts into a bit over a thousand dollars…
The price guarantee is to be funded through borrowing, and according to The Institute
for Fiscal Studies, the two-year energy package is likely to cost £100bn (or 4 per cent of
GDP) in the first year alone.
Its total cost might be 150 billion pounds (or dollars or tethers).
The Bank of England’s chief economist said at the time that the extra government borrowing,
and spending would likely lead to higher interest rates in the future.
Investors sold UK assets earlier this month after this announcement, sending the pound
down against the dollar, which reached its weakest levels since 1985.
Something did have to be done about high UK energy prices, in particular because energy
prices make up a very high percentage of the costs of the most vulnerable in society.
So, there’s a good argument that any support should have been targeted to reach those who
are suffering the most through energy inflation.
Possibly offering means-tested support would have made the overall package a lot cheaper
and the economy would have been better able to sustain such a package should the current
high prices drag on longer than is expected.
Manoj Pradhan and Charles Goodhart at Talking Heads Macro estimate that this support package
benefits the wealthy in the UK 2-3 times as much as it benefits the poor.
So maybe it is not as well designed as it could have been.
On top of this, high prices send an important economic signal to consumers encouraging them
cut back on consumption when prices are high.
A broad-based price freeze like this mutes that signal, meaning that those who can still
afford the high energy prices are less likely to cut back on consumption than they might
otherwise be.
So, the Pound began declining again on Friday and over the weekend reaching its lowest level
ever against the US dollar today.
This decline came after the announcement of Kwasi Kwarteng’s £45bn tax-cut package
on Friday.
The tax cuts were put in place with the goal of boosting economic growth.
The slide in the value of the pound prompted numerous jokes comparing the Pound to an emerging
market currency.
We will talk in just a moment about why the idea of a looming EM style sterling crisis
doesn’t make an awful lot of sense at present.
A declining pound (I should first note) is not a new thing.
The Pound has been falling against the dollar ever since the end of the Second World War
when the Pound was worth around four dollars.
The reason for this consistent depreciation is just that UK inflation has been persistently
higher than US inflation over that period, and the exchange rate had to fall in order
to equalize price levels in the two economies.
The recent fall in the pound is driven by investors selling British assets because they
have doubts about the soundness of the government's plans.
This is driven by concerns about the British economy rather than just being related to
dollar strength.
The pound has fallen by more than 7 per cent against the currencies Britain’s international
trade partners since the start of August.
From a markets perspective, the tax cuts, combined with increased government spending
at a time like this is what’s causing the slide.
Economists probably wouldn’t recommend these actions, but they appeal to politicians in
the same way that releasing oil from the Strategic Petroleum Reserve might appeal in the United
States.
It gives voters the feeling that politicians are doing something for them in a time of
high inflation, close to elections.
The reason that stimulating the economy with tax cuts might not make sense in the UK right
now is that the UK unemployment rate is very low at present and there is very little spare
capacity in the economy for non-inflationary growth.
Spare capacity in economics describes the extent to which an economy is operating below
the maximum sustainable level of production.
Spare capacity depends on the balance of demand for goods and services relative to the economy’s
ability to produce those goods and services.
When there’s not enough demand, you see spare capacity which puts downward pressure
on inflation.
If there is too much demand, this results in capacity being constrained and you see
upward pressure on inflation.
A key indicator of how much spare capacity exists in an economy is the unemployment rate.
A high unemployment rate means that there is a large pool of workers willing to work
but not engaged in production, suggesting that the economy is operating below its potential.
In such a situation Economic stimulus can cause businesses to hire more people stimulating
demand without causing inflation – which is a positive outcome.
The rate of unemployment that is in line with an economy producing close to its potential
is associated with a stable rate of inflation, so it’s known as the ‘non-accelerating
inflation rate of unemployment.
When unemployment deviates from this level, it suggests that the economy is producing
either above or below its prevailing potential.
The tax cuts in the UK when unemployment is very low, as it is right now, and inflation
is a problem is likely to just push inflation even higher.
The decline in the pounds value, that we have just seen is also likely to be inflationary,
so none of this does anything to help the UK’s inflation rate or cut into the cost-of-living
crisis.
Trading in the pound was the most volatile we have seen since the start of the pandemic
in early 2020.
The currency swung more than 5 per cent from its daily high and low points today.
In a statement on Twitter, the Bank of England said it was monitoring developments and would
"not hesitate to change interest rates by as much as is needed to return inflation to
the 2% target" and the UK chancellor Kwasi Kwarteng in an attempt to reassure markets
that he is serious about bringing debt under control announced that he was bringing forward
plans to publish a new medium-term fiscal strategy to November 23rd.
Previously he had not been expected to announce his new debt strategy until the new year.
The Bank of England’s announcement that they would not assess the turbulence in financial
assets until their next planned meeting in November reduced the probability of any emergency
rate hike to traders — this was likely the reason that the pound fell to under $1.07
from its high of the day of $1.09.
Markets are currently expecting the Bank of England to raise rates to over 5 per cent
next year, and the cost of government borrowing has increased.
Ten-year borrowing costs have risen from just over one per cent at the start of the year
to over 4 per cent today.
The Bank of England had just raised interest rates by half of a percent on Thursday, after
a third successive 75 basis point rate increase by the US Federal Reserve a day earlier.
Manoj Pradhan at Talking Heads macro says that a ratings downgrade by credit rating
agencies looks increasingly likely given the events of the last few days but is not being
discussed at all in the press.
He says that a downgrade would probably not have much impact on market pricing, but it
would put significant political pressure on the conservative government.
He says that there are two possible paths, and that both look extremely difficult.
The first path is that the Truss administration could decide to just ride through the market
storm, ignore foreign exchange weakness and hope that the Bank of England can stabilize
the Pound.
He says that the can won’t get kicked very far down the road with such a strategy.
An emergency 100 (or 150) bps increase in policy rates (on top of what was priced in
before the tax cuts) could help satisfy markets and bring some stability to the pound but
that would make economic (and thus market) conditions much worse in the future.
An increase in policy rates of that magnitude when the level of debt is so high would mean
an even higher deficit in the future.
That would happen for two reasons.
First, it would more than reverse the entire benefit of the fiscal expansion, and second,
the interest expense would rise due to the higher interest rates and the higher level
of debt in the economy.
The second path that Manoj says could happen is that a politically embarrassing backtracking
occurs.
He argues that backtracking towards a more conservative fiscal stance would likely be
more popular among Conservatives in Parliament.
But, it would hand an embarrassing political victory to the Labour party.
He argues that backtracking like this has the potential to take the new administration
down and plunge the UK into another search for Prime Minister.
OK, so I mentioned earlier that it is not reasonable to expect an Emerging markets style
currency crisis in the UK.
There is a very good Reinhart and Rogoff paper on how these things work, but, typically,
there are two ways a country with a floating exchange rate can have a currency crisis,
and neither applies to the UK at present.
Usually, a currency crisis happens when a country has large external liabilities that
are denominated in a foreign currency.
As the home currency depreciates, the debts grow.
This creates a self-reinforcing downward spiral.
The UK does have a lot of external liabilities, but they're mostly British Pound denominated.
The UK also has external assets, mostly direct investments abroad.
For these assets, currency depreciation is actually good for the UK.
So, a currency crisis of this sort doesn't seem likely.
Now, the other way you can have a currency crisis is if a substantial percentage of a
country’s debt is held by international investors who lose faith in either the country’s
ability or it’s willingness to service that debt.
But the independent Bank of England is unlikely to monetize debt like that, and additionally,
UK debt isn't that large by long-run standards.
So, once again, unlikely.
Now, I know that a lot of my viewers are based in the United States, so how might this affect
you?
Well, the president of the Atlanta branch of the Federal Reserve announced a few hours
ago that the UK government’s new fiscal plan has increased economic uncertainty and
raised the odds of a global recession.
He said that “a basic tenet of economics is more uncertainty leads to less engagement
by consumers and businesses,” – he went on to say “The key question will be, what
does this mean for ultimately weakening the European economy, which is an important consideration
for how the US economy is going to perform.”
If you enjoyed this video, you should watch this one next.
Have a great day and talk to you again soon.
Bye.