A Bad Week in Britain

Ichiro Suzuki As soon as Queen Elizabeth’s state funeral was over, Britain was thrown into financial markets’ turmoils. Markets revolted against an economic policy of the new prime minister, whose appointment was the final job by the Queen. Ms. Liz Truss won a party election to lead the Tories, advocating tax cuts and deregulation as well as huge energy subsidies, and Chancellor of the Exchequer Kwasi Kwarteng duly delivered a mini budget that reflected her policy. In the final week of September, the markets fiercely sold down bonds, known as gilts, and the British pound. Long-term interest rates spiked up and sterling was brought down to its new low against the U.S.cdollar, which eclipsed the level witnessed 37 years ago on the eve of the Plaza Accord. The turbulence in the gilt market has immediately hurt pension funds through their derivatives contracts that intended to hedge against lower gilt prices. The Bank of England intervened in the market to contain gilt yield’s rise to calm down the uproar, switching its gear from quantitative tightening (QT) back to quantitative easing (QE) again. PM Truss brought back the playbook of Ronald Reagan and Margaret Thatcher. Supply side economics was a popular buzzword in the early 1980s. Since then the markets have learned so much about it with a good grasp of its pros and cons. This time around, the markets refused to subscribe to unfunded tax cuts that Mr. Kwarteng said would pay for themselves. In 1980, supply side economics sounded so fresh after over a decade of lax fiscal policy that led to a bigger government while debt levels were much smaller than today. In addition, after the pandemic and the war in Ukraine, tide has turned against small state, low tax and liberating instincts. Building resiliency has replaced relentless pursuit of efficiency in the business world, as showcased in realignment of supply chains. So the mini-budget led to a loss of confidence in the British government. While Britain is running a much smaller government debt outstanding to GDP at 86% than Italy (122%) and Greece (157%), what mattered was the direction that a policy is taking the country to. Confidence has got crushed. PM Truss and Chancellor Kwarteng are too young to remember the crises sterling suffered before Mrs. Thatcher’s arrival. In response to the market’s revolt, PM Truss has taken back tax cuts for high earners: a cosmetic change since a large part of the planned tax cuts remains intact. French President Giscard d’Estaing once called the dollar’s reserve currency status as an exorbitant privilege. The U.S. Treasury Department does not have to be as sensitive to its currency as their trade partners are. Every single international prices are quoted in the USD and trade partners pay in the greenback willingly or grudgingly. A weak dollar loosens financial conditions in the global economy with greater circulation of dollar notes in the financial markets. A weak U.S. currency isn’t so bad for the world. No such privilege is given to Britain or anyone else. The British economy has got out of the largest trading bloc on earth without a deal to replace it. The economy is in the process of massive structural changes though few have a clear idea about its shape after such changes. The economy has been relatively weak in part due to lack of investments since the 2007-09 global financial crisis. Worse, the country is running large current account deficits at 7-8% of GDP. The size of the deficit is much greater than approximately 5% that the U.S. once ran in the years that preceded the financial crisis. Running big deficits was a luxury sometimes allowed only for the U.S., and the market gives harsh reactions when other countries tried to emulate it. As far as fall of the currency is concerned, the Japanese yen is faring even worse than the British pound, so far into 2022. The yen’s fall, however, has been rather orderly, in response to a widening interest rate gap against the U.S. Japan’s worsening long-term economic picture might be also in the price, to a certain extent. Nonetheless, a weak yen is not the market’s refusal to accept the prime minister’s economic policy. Against all odds, the Bank of Japan has been successfully managing interest rates’ long end, maintaining 0.25% or lower on 10-year government bond yield. The BOJ is very well functioning as market maker of last resort. In order to calm down the panicked gilts market, the Bank of England employed yield curve control, borrowing from the BOJ’s tool box. A panic was calmed down and sterling has bounced back from record low levels near the parity against the greenback. Unlike the BOJ, the BOE may not play a role of market maker of last resort indefinitely. So it remains to be seen how the market behaves when support is lifted. It looks what separates Japan and Britain is the current account. Japan’s current account is under pressure in recent months, pressed down to its worst levels in years by rising crude oil prices and a falling currency. Nonetheless, it has only slipped modestly into a negative territory after years of registering abundant surpluses at 2-3% of GDP, which sometimes is viewed as not too healthy (though healthier than Germany’s obscene 8%). This makes Japan a great deal less dependent on a whim of foreign capital to finance its external account. The flip side of this ‘strength’ is that it is making policy makers and voters complacent, not pressing them hard enough for change they need. In contrast to the market’s revolt against gilts, Japan is relatively stable at this moment but might not be too far behind Britain. It might be less hard to crush the confidence in the BOJ than it is widely believed today.


About the author: Mr. Suzuki is a retired banking executive based in Tokyo, Japan.