The U.K.'s Inflation Band-Aid Caused More Problems Than It Solved

Britain's financial minister had his own plan to fight inflation...

Last week, we wrote about how Federal Reserve Chair Jerome Powell is pulling out the 1970s playbook to combat rising prices. But the U.S. isn't the only turbulent economy these days.

Germany is facing an energy crisis. Sanctions against Russia have disrupted supply chains throughout Europe. And tenuous relations between the U.S. and China have everyone on edge.

Now, the U.K. is feeling the pressure.

When Liz Truss became prime minister in September, she quickly assembled a new team to help England's economy. One of her new appointees was Chancellor of the Exchequer Kwasi Kwarteng. His role was very similar to what Powell does here in the U.S.

Like the U.S., the U.K. has fluctuated in 2022. It needed someone new to address the many problems it has been facing. So not long after Kwarteng started, he announced a plan to kick-start Britain's tumbling economy.

He proposed historic tax cuts and massive borrowing increases. He also removed the highest tax bracket... ended the limit on banker bonuses in London... capped corporate tax rates... initiated a £60 billion program to control energy prices... and was pushing for more infrastructure investments.

This should have boosted the U.K. economy – in theory. But not all plans work out...

Kwarteng revealed this proposal to the British government on September 23. The market reacted almost immediately.

Within a few days, the British pound plummeted. The pound-dollar exchange rate plunged to $1.10, a 37-year low.

The pound wasn't the only thing that was hurt, either. The cost of borrowing skyrocketed...

Interest rates for the gilt – the term for U.K. Treasurys – soared as a result of the unpopular proposal. Rates for 10-year gilts rose to 4.1%. Two-year rates spiked to 4.4%. And 30-year rates soared above 5%, the highest level in 20 years.

Kwarteng's disastrous proposal culminated in his getting fired last Friday. He failed because the market saw his idea for what it was... a Band-Aid solution.

It was a short-term massive stimulus plan for the economy that would put the U.K. in a more challenging position going forward. Worst of all, there was no clear way to know when the government would get paid back for its stimulus measures.

This debacle proved that, despite what some economists believe, governments cannot simply borrow at will and throw money at problems without consequences.

And it had another effect, too...

Kwarteng's proposal reignited a yearslong debate on modern monetary theory ('MMT')...

If you're not familiar, MMT is a somewhat new economic theory. (It was created in the early 1990s.) The premise is that the governments of developed countries can borrow as much as they want, at will, without impacting yields.

Said another way, MMT suggests that governments should borrow and spend to stimulate their economies without worrying about how they're going to pay off those debts.

It used to be that if a government borrowed too much or made irresponsible decisions, the "bond vigilantes" would come knocking. Investors would send bond yields higher, and bond prices would crater. That would force governments to get their acts together.

MMT assumes that those bond vigilantes have been tamed. It holds that governments can – and should – be more aggressive with stimulus.

Here's the problem... MMT sounds good in theory, but it can create even more issues down the line. There's no mechanism in place to guarantee the government will ever pay its bills. That can drive inflation higher in the long run.

Kwarteng's move was something of a surprise. If you were to bet on who would test the efficacy of this concept, you probably wouldn't choose a brand-new conservative prime minister and chancellor.

After seeing the U.K. proposal, the bond vigilantes made their voices heard. Kwarteng gambled with the country's monetary and fiscal policy to solve its economic woes. Investors weren't happy. And now, the country is worse off for it.

No matter your politics or stance on economic policy, one thing should be clear – there's no such thing as a free lunch. If you aren't responsible with your money, the markets will react accordingly.

Regards,

Joel Litman
October 17, 2022