OPINION
Why Is the British Pound Getting Pounded?
Sept. 27,
2022, 1:06 p.m. ET
Paul
Krugman
By Paul
Krugman
Opinion
Columnist
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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
Vladimir Putin’s de facto natural gas embargo. Rather than raising taxes to
help cover this expense, however, Truss’s chancellor of the Exchequer —
basically her Treasury secretary — announced tax cuts, notably a big reduction
in taxes on the highest earners.
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 impact of deficits rather than acting to offset
them. These days, the bank is not only independent; it has a mandate to keep
inflation low.
So why the
sudden run on the pound? One answer I liked came from the 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 on 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 1992-3, however, the European E.R.M. 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.
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