Learning the wrong lessons

The UK macro-policy mix looks awful. Again.

The meme that “the UK is an emerging market now” is overdone. But in terms of macro-policy it currently feels almost fair.

Stepping back: the country has endured a negative terms of trade shock, inflation is uncomfortably high and real household incomes are taking a huge hit. The economy is almost certainly already in recession.

Given that the jobs market is tight (increasing driven by weak labour supply rather than high labour demand) and core inflation is running well ahead of normal levels, then the Bank of England tightening policy is at least understandable.

What is less explicable, at least from first principles, is the coming simultaneous tightening in fiscal policy.

As Giles Wilkes aptly put it this week:

The UK government is acting like it is running a developing market economy in the late 1990s, the kind with an immature financial system and untrusted currency, ordered by the Washington institutions to tighten both monetary and fiscal policy at once. 

Defining which countries are emerging markets and which are developed markets is tricky. But by own preferred definition is straight forward: developed markets have the ability to utilise counter-cyclical policy. Toby Nangle, was entirely right about this back in 2019:

If you live in a Developed Market it means that you are pretty likely to be well-off individually (when measured on a global scale). But it also means that you benefit from Developed Market Privilege: your government can run counter-cyclical monetary and fiscal policy.

Reducing (rather than raising) interest rates, and loosening (rather than tightening) government purse strings when an economic downturn comes might sound like common sense. And for Developed Market economies it is. But if you are an Emerging Market (EM) economy, things aren’t quite as simple. For EM economies, rate cuts and easier fiscal policy (that might help cushion the blow of a slowing or shrinking economy) might well be met by currency weakness, rising inflation, and a higher risk premium applied to the country’s debt and financial instruments by foreign (and domestic) investors, all of which might be somewhat counterproductive to the happiness of EM citizens. Bottom line, in the words of my interlocutor “at the risk of provoking the fixed-income goblins, the shibboleth is ‘in risk-off, am I buying or selling your debt?’”.

Memes aside, the UK has not lost its developed market privilege.

It is important, at this point, not to learn the wrong lessons from the short-lived Truss government.

The conventional wisdom seems to be becoming: “Truss and Kwarteng abandoned fiscal discipline, markets reacted incredibly badly and interest rates shot up”. The argument is implicitly that ‘yes, fiscal tightening is going to hurt but it’ll hurt less than interest rates soaring’.

It’s a perfectly understandable argument but I’m not sure it at all fits the picture of what happened a few weeks ago.

To start with, I think the initial reaction to the mini-budget was as much about the vibes as the policies. The vicious response in markets was not just to the £45bn tax package, it was about the denigration of economic institutions (sacking Tom Scholar, the lack of an OBR forecast, the questioning of the BOE’s mandate), the fact that the package was about 50% bigger than expected, the ‘iffy’ costings of the energy price bail-out and the loose talk of more tax cuts to come in the days after the budget.

It was hard to imagine a series of steps from British policymakers more likely to spook the markets.

The process as much as the policy itself mattered.

But more importantly than that, it appears pretty clear that the gilt sell-off had two distinct drivers – one related to economic fundamentals and one driven by technical factors.

At the level of fundamentals, the story was straight forward:

The BOE was already raising interest rates to bring inflation back to target. Given that looser fiscal policy would add to demand and hence spending the Bank would have to raise interest rates at a faster pace and to a higher terminal value to offset the government’s actions. Looser fiscal policy meant tighter monetary policy and therefore, gilts fell in value.

But that was not all that was going on. There was also the LDI debacle. Which, in the words of the BOE, risked a ‘fire sale dynamic’ in the gilt market. As gilts fell in value some funds found themselves having to sell gilts to meet margin calls adding to downward pressure and risking a negative feedback loop.

The 30-year gilt yield jumping from around 3.5% to 5% in a matter of days did not reflect a considered fundamental view of the likely path of UK rates and the economy. It was driven by margin calls rather than a rational assessment of the economic future.

That matters because painful as that accident was, it is also one unlikely to be repeated.

Would a looser path of fiscal policy in the months ahead lead to tighter policy from the Bank of England? Very probably.

Would a looser path of fiscal policy in the years ahead see a repeat of late September/October and a possible financial crisis? Almost certainly not.

Fiscal rules are a useful thing. But they need to take account of the economic cycle and focus on the medium term. Rules that require adding to a downturn are bad rules. Promising to do incredible things is not the route to credibility.

The biggest package of tax cuts in 50 years – funded by borrowing – was an irrational fiscal policy choice for an economy with comfortably high inflation and an independent central bank already raising interest rates. A sharp tightening of fiscal policy now even as consumer demand dries up is equally inappropriate.

Yes, looser fiscal policy – at a time of high inflation and rising interest rates – incurs a cost. But that cost needs to be set along the benefits. The UK still has its developed market privilege, it should use it.