On September 23^rd, the British government announced a new program of energy subsidies, and income tax reductions aimed at stimulating growth. The tax reductions were the country’s biggest in a very long time. The government indicated that both the subsidies and tax reductions would be financed with additional debt as opposed to expense reallocations and cuts. The government insisted that it was acting responsibly and doubled-down on its commitments. The announcement was made despite ongoing efforts by the Bank of England to tighten monetary policy in order to fight annual inflation of approximately 10%, the highest among major economies. Less than a month later, the government backtracked on its plans and the British Prime Minister resigned. The change in direction came after intense market pressures and deliberate warnings.

Intense Market Pressures

Market reactions were swift and very negative. Following the announcement, the British pound sank 3% against the U.S. dollar, the biggest single-day drop in two years.¹ The sudden drop came in addition to a loss of value of almost 20% during the previous twelve months, bringing the pound close to an all-time low relative to the U.S. dollar. The 12 month decline resulted from the Bank of England not keeping pace with U.S. interest rate increases to combat inflation.² The significant drop of currency value makes British imports more expensive, which contributes to domestic inflation. Alternatively, the weaker value makes British exports more competitive, which helps stimulate economic growth. But large variations of currency values over a short period of time are not signs of economic stability. Figure 1 illustrates the downward trend of the British pound since January 2022.

After the announcement, the yield (effective interest rate) of British government bonds rose by approximately one percent across maturities. Long term bond values dropped by almost a third in only three business days.³ The rapid decline of bond prices causing yields to rise quickly was a clear sign that investors were dumping government bonds. The selloff forced the Bank of England to intervene in order to restore market stability. For this purpose, the bank announced a temporary government bond buying program. “Were dysfunction in this market continue to worsen, there would be a material risk to U.K. financial stability” the bank said in a statement.⁴ Such a program is not consistent with fighting inflation because it lowers long term interest rates and increases money supply. It was carried out in contradiction with other actions aimed at reducing inflation. Figure 2 illustrates the rise of U.K. government bond yields following the September 23^rd announcement.

Deliberate Warnings

Soon after the announcement, many economists pointed out that the government plans were likely to “fuel already high inflation, sink the pound and drive up the cost of U.K. government borrowing – a potential perfect storm of economic headwinds.”⁵ The current situation “gives the appearance of both the Bank of England flip-flopping on policy, as well as being willing to finance a rise in government debt. These optics raise concerns around central-bank independence, pushing down on [the pound] sterling and up on inflation” said Katharine Neiss, a former Bank of England economist.⁶ There is concern about a “lack of coordination” between the Bank of England and the Treasury Department, noted Raoul Ruparel, a director for the Boston Consulting Group Center for Growth. “No one knows who one is going to win out and that causes anxiety” he added.⁷

In particular, the announcement of tax reductions sparked concerns that government debt was spiraling out of control. “We worry that investor confidence in the U.K.’s external sustainability is being eroded fast,” said George Saravelos, head of foreign exchange at Deutsche Bank.⁸ As a result of the bond market turmoil “it now costs the U.K. more to borrow over 10 years than Italy or Greece” observed Charles Bean, a former Bank of England deputy governor.⁹  “Much of the investor concern isn’t necessarily about whether the U.K. government will honor its debts, but rather a view that the tax cuts will spur higher interest rates and thus check much of the economic growth that the government hopes to achieve,” said Kallum Pickering, senior economist at Berenberg.¹⁰

The International Monetary Fund (IMF) urged the British government to reconsider its plan. “We are closely monitoring recent economic developments in the U.K. and are engaged with the authorities,” an IMF spokesperson was quoted as saying in response to questions about the market turmoil. “Given elevated inflation pressures in many countries, including the U.K., we do not recommend large and untargeted fiscal packages at this juncture, as it is important that fiscal policy does not work at cross purposes to monetary policy,” she further added.¹¹ These official comments came after repeated IMF warnings in recent months of the “need to carefully calibrate fiscal and monetary policy as central bankers raise interest rates across the globe to get inflation under control.”¹²

Fiscal Policy Reversal

On October 21^st, the British Prime Minister resigned. The resignation came soon after the government cancelled most of its planned tax reductions, pared back the program of energy subsidies, and promised spending cuts to bring government debt under control. “I want to confirm that [the next budget] will demonstrate debt falling over the medium term, which is really important for people to understand” said Jeremy Hunt, the newly appointed official responsible for treasury and finance.¹³ “There will be more difficult decisions, I’m afraid, on both tax and spending as we deliver our [new] commitment to get debt falling as a share of the economy.¹⁴ We are a country that funds our promises and pays our debts” he further added.¹⁵ The updated British government plan is undoubtedly one of the most spectacular reversal of fiscal policy in modern history.

Lesson Learned

Market and price stability are preconditions for economic growth. The U.K. experience clearly demonstrates that unfunded programs, runaway deficits, and high levels of debt are imprudent, especially when they are inconsistent with monetary policy objectives. “Fiscal policy should not undermine monetary policy” said Kristalina Georgieva, managing director of the International Monetary Fund.¹⁶ The British government was tempted to roll-out massive fiscal stimulus aimed at generating economic growth. However, it soon realized the hard way that such measures are not advisable in a context of high inflation and tightening monetary policy actions.

The U.K. experience should be viewed as a cautionary tale and a welcome warning for all governments. “In an environment where borrowing costs are going to be higher – in my judgment, higher not just in the short term, but in the medium term – fiscal discipline is imperative” observed Mark Carney, former governor of the Bank of Canada and Bank of England. “One of the lessons is that sound monetary policies and credible fiscal policies will be rewarded, but mistakes will be punished. The U.K. experience underscores that it is counterproductive for fiscal and monetary policies to work at cross purposes” Mr. Carney further stated.¹⁷

The government miscalculation was to believe that massive fiscal stimulus and higher deficits financed with additional debt continue to be appropriate in a context of high inflation and rising interest rates. “It was the combination of the wrong fiscal policy at the wrong time – borrowing when rates are rising rather than when they were low as in the 2010’s” said Jonathan Portes, a professor of economics and public policy at Kings College London.¹⁸ The U.K. experience may be “the canary in the coal mine” of additional economic lessons to come according to Kenneth Rogoff, a professor of economics at Harvard University and a scholar of financial upheavals.¹⁹

__________________________

¹ Paul Waldie, “Truss’s economic plan sends British pound plummeting” (Globe and Mail, September 27, 2022)
² Danica Kirka and Jill lawless, “British Pound Sinks To Record Low” (National Post, September 27, 2022)
³ James Mackintosh, “Britain’s Financial Disaster is a Warning to the World” (Wall Street Journal, October 1, 2022)
⁴ Paul Hannon and Chelsey Dulaney, “Bank of England Buys Bonds in Bid to Stop Spread of Crisis (WSJ, Sept. 2022)
⁵ Danica Kirka and Jill lawless, “British Pound Sinks To Record Low” (National Post, September 27, 2022)
⁶ Tom Fairless, “Central Banks’ Higher Rates, Bond Sales Clash With Government Needs” (WSJ, October 2, 2022)
⁷ Paul Hannon and Max Colchester, “U.K. Seeks to Calm Investors (…)” (Wall Street Journal, September 27, 2022)
⁸ Danica Kirka and Jill lawless, “British Pound Sinks To Record Low” (National Post, September 27, 2022)
⁹ Paul Hannon and Max Colchester, “U.K. Seeks to Calm Investors (…)” (Wall Street Journal, September 27, 2022)
¹⁰ David Luhnow et.al., “British Pound, Bonds Roiled as Tax-Cut Plans Spook Investors” (Wall Street Journal, Sept. 26, 2022)
¹¹ Andrea Shalal, “IMF Says UK Fiscal Measures Will ‘Likely Increase Inequality,’ Urges Rethink” (Reuters, Sept. 27, 2022)
¹² Andrea Shalal, “IMF Says UK Fiscal Measures Will ‘Likely Increase Inequality,’ Urges Rethink” (Reuters, Sept. 27, 2022)
¹³ Danica Kirka, “U.K. Finance Minister Delays Detailing New Economic Plans” (National Post, October 27, 2022)
¹⁴ Philip Aldrick, “U.K. Recession Looms After New PM’s Growth Program Backfires” (National Post, October 18, 2022)
¹⁵ Max Colchester and Paul Hannon, “U.K. Treasury Chief Jeremy Hunt Reverses Nearly All Tax Plans to Reassure Markets”
(Wall Street Journal, October 17, 2022)
¹⁶ Max Colchester et.al., “U.K. Markets Rally as Investors Bet Government Will Roll Back Tax Plans” (WSJ, October 13, 2022)
¹⁷ Stephanie Hughes, “Carney Says Fiscal Discipline ‘Imperative’ To Combat Global Inflation, Instability” (NP, Oct. 21, 2022)
¹⁸ Mark Landler, “Truss Defied the Markets, and the Bond Traders Sealed Her Fate” (Globe and Mail, October 21, 2022)
¹⁹ Mark Landler, “Truss Defied the Markets, and the Bond Traders Sealed Her Fate” (Globe and Mail, October 21, 2022)