As an Englishman who makes his home in the United States, it gives me no pleasure to say this, but the UK is a mess right now. The Chancellor of the Exchequer (the British equivalent of a finance minister or Treasury Secretary) has reportedly been fired today as the government sets about the embarrassing task of reversing the only thing they have done so far on an economic front. From my perspective, the relevant question is whether that mess means anything to U.S. investors. The answer, unfortunately, is yes it does. Perhaps not so much in an immediate sense, but rather in terms of its longer-term implications.
There are lots of reasons for the chaos that reigns across the pond. Liz Truss took over as leader after her predecessor, Boris Johnson was caught up in a series of scandals, so the situation was unstable from the start. However, she and the Cabinet she appointed have only made things worse. Most of all, their “signature” economic policy so far, trying to buy the electorate’s favor with unfunded tax cuts, was foolish, probably even reckless.
From a political perspective, simply making cuts to the top tax rate looks like a naked attempt to appeal only to the Conservative Party’s core and is seen as a major insult by the majority of the the country, who are not in the top tax bracket and are struggling to pay for basics like food and energy. That may lead to Truss being forced to resign, and possibly even a general election. The political implications, however, pale in comparison to the economic and market impacts of the decision.
Currency and bond traders responded in a logical way to a government cutting its own funding when it was already struggling to pay for existing programs, by selling off both the Pound and UK Government bonds, known as Gilts. The selling became so intense that the Bank of England felt they had to intervene to prop up the Gilt market, completely reversing the policy path of monetary tightening that they were on. I have seen firsthand the inevitable outcome when the market senses that the central bank is being forced by political decisions into intervening, and it didn’t end well that time.
That was in 1992, and it ended in a day known as Black Wednesday, when the Bank’s efforts to prop up the Pound were abandoned due to market pressure. I was working on an interbank forex desk in London at that time and got a sense of the pack mentality that takes over when traders feel that they have a central bank on the run. Our motivation then was simply to make money — that is our job after all — but in pursuing that, we, the forex market, asserted an important principle: the primacy of markets in a capitalist system.
Elected governments, not money-chasing traders, do and should make the rules in a democracy. But if they do so foolishly, without regard for economic reality, the market has the power to override them and force embarrassing and politically damaging U-turns. That is what is happening right now in the UK, but the potential problems come after that reversal takes place.
There is a danger that the weakness in Gilts will become not a symptom of a problem, but the problem itself. If the market senses real weakness, then as we saw thirty years ago, no central bank has the power to prop something up above its perceived market value. That is a problem because the Gilt market is well over $2 trillion in size. A collapse would impact the liquidity and stability of not just UK banks, but banks in all of the developed world. We saw how that shook out in 2008 during the Great Recession.
Of course, it could be that the reversal of the Truss government will prove to be enough for traders. They may decide that they have done their job and back off. My fear, though, is that now they smell blood, they will, at some point soon, go in for the kill. If that happens, then global financial instability may follow, and the current worries in the U.S. about inflation and rate hikes will be quickly forgotten as the markets respond to a much bigger danger. We should all hope that doesn’t happen and that over the next few days, Liz Truss can reverse the damage she has wrought.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Image and article originally from www.nasdaq.com. Read the original article here.