FA Alpha Daily

The U.K.’s Anti-Inflation Efforts May Have Done More Harm Than Good

Feeling the pressure, newly appointed Prime Minister Liz Truz, sets new appointees to address the tumbling economy of U.K. One of her new appointees, the chancellor of the Exchequer Kwasi Kwarteng, revealed his plan to boost the U.K. economy by proposing tax cuts and increasing borrowings. In today’s FA Alpha, let’s examine this recent move and how the newly appointed leaders could save the British economy.

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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.’s economy has fluctuated in 2022. It needed someone new to address the many problems it has been facing.

Not long after Kwarteng started, he announced a plan to kickstart the tumbling economy. He proposed historic tax cuts and massive borrowing increases. He also removed the country’s 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 all boost the U.K. economy – in theory. But that’s not how it played out. Kwarteng revealed this plan 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. The cost of borrowing skyrocketed..

Interest rates for the gilt – the term for U.K. Treasury – 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.

And just last Friday, Kwarteng got the boot from his job. The mess his ideas made was so bad that PM Truss needed to make a clean slate.

Kwarteng’s proposal failed because the market saw it 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 ideas reignited a years-long 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 at will as much as they want 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 those debts off.

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 shooting higher and bond prices cratering. That would force governments to stop acting irresponsibly.

MMT assumes that the bond vigilantes that used to keep developed market governments in check had been tamed. Governments could and should be more aggressive with stimulus.

If you were to bet on who would test the efficacy of this theory, you probably wouldn’t choose a brand-new conservative prime minister and chancellor.

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.

And so after seeing the U.K. proposal, the bond vigilantes spoke. 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.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

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