Thought of the Week - Why Trussonomics cannot work
It has been a whirlwind two weeks for me since the new UK government launched its not so mini-budget that caused maxi-damage to Sterling and the Gilt market. But now that the initial panic has subsided and I have had time to take care of some loose ends in my day job, I have time to sit back and heed the advice of my wife who always reminds me to go back to “first principles” when assessing difficult situations. Normally, I focus on empirical results because I try to understand the world as it is, not as some theory says it should be. Yet, this is one instance where thinking about the proposed new government policies in a more fundamental way can help us understand why these policies simply cannot and will not work in the UK.
The first thing to understand about the UK and indeed the US and all other developed countries is that trend GDP growth today is much lower than it used to be due to ageing demographics, declining productivity growth and rising income inequality. The OECD estimates that trend growth in the decade from 2020 to 2030 in the UK will average 1.8% per year (1.7% in the US and 1.2% in the Eurozone). Trying to average 2.5% real GDP growth as the Chancellor in the UK proclaimed on 23 September is practically impossible in the long term. If you try to push growth so far above trend, you are inevitably causing high inflation that needs to be reined in with higher interest rates and a recession. You might get a year or two of 2.5% growth, but the economy and the people will pay the price afterwards in the form of low and negative growth.
Such low trend growth also means that the natural real rate of interest is very low indeed. Economic theory says it should be somewhere in the 1% to 2% range but, practically, it might even be lower than that. After all, I showed empirical results here about the long-term downward trend in real rates that indicates that the natural real rate of interest may be zero or even negative. But if the natural real rate of interest is that low, fiscal and monetary policy get into serious trouble.
Jean-Baptiste Michau has published a nice paper that shows that in a low interest rate environment, a country can achieve at best two out the following three goals:
1. Low inflation
2. Full employment
3. Low government debt with no Ponzi scheme
What does he mean by low government debt with no Ponzi scheme, you may ask? Well, it means that the government is running deficits that are so low that they can credibly be paid back in some distant future through higher tax revenues or government spending cuts. If the government must resort to new borrowing to pay maturing debt, government deficits become in effect a Ponzi scheme where new debt is used to pay off old debt and the debt mountain will grow indefinitely.
I will spare you the details of Michau’s paper which is full of formulae and give you a summary of its main findings.
Assume you are an economy with low trend growth and hence a low real rate of interest. If you have low inflation, the central bank may be tempted to achieve full employment by reducing the real rate below the natural rate of interest. However, if inflation is low and the natural rate of interest is low, the central bank may reduce nominal interest rates to zero and still encounter a situation of real rates that are similar to the natural rate of interest. But if real rates are about the same as the natural real rate, there is no economic stimulus from monetary policy and employment will not rise. The zero lower bound acts as a limit to the power of monetary policy.
This is the situation that the US, the UK and the Eurozone found themselves in from 2008 to 2020. No matter how low central bank policy rates dropped, unemployment rates would not drop by much and inflation remained stubbornly low. In this environment, you need to increase budget deficits to stimulate growth and generate higher employment. And you typically must increase budget deficits to levels that are unsustainable in the long run. This is what most countries did during the Covid pandemic. They turned their fiscal policy into a temporary Ponzi scheme to save us from a major global depression. The result was higher employment and higher inflation.
But the fiscal stimulus of the pandemic was temporary in nature and never intended to be permanent.
On a long-term basis, most countries across Europe as well as the US have so far committed themselves to sound fiscal policies that are not a Ponzi scheme. Furthermore, central banks in these countries try to bring inflation down to the 2% target they aim for. This means that the real rate has to rise to levels above the natural real rate, creating a slowdown in growth and higher unemployment. And because fiscal policies remain sound and no fiscal stimulus is unleashed to boost growth, that means growth will remain structurally low. This is the route that Germany, France, the US, Canada, etc. have taken. The price to pay for low inflation and sound fiscal policies is a recession and high unemployment in the short term and structurally low growth in the long term.
There is one developed country that has gone down a different route, though. A route of low inflation, full employment and a government debt situation that is effectively a Ponzi scheme: Japan. Japanese unemployment numbers are something to behold. They currently stand at 2.5%, having steadily declined from 5.4% in September 2009. But famously low inflation and low unemployment in Japan have come at the price of the government running persistent deficits in the 6% to 8% of GDP range each year and accumulating a debt/GDP-ratio of 260%. The risk of this Ponzi scheme of government debt is that there is a small probability that investors will stop buying Japanese government bonds, creating both a debt crisis and a currency crash in the Japanese Yen.
Which brings us to the proposed change in fiscal policy under Prime Minister Liz Truss in the UK. What the Chancellor of the Exchequer effectively did on 23 September with the mini-budget was to say that the UK will deviate from the path of the US and much of continental Europe and stimulate growth through increased budget deficits. Instead of accepting low growth as a price to pay for low inflation and sound fiscal policies, the government put the UK on a path similar to Japan of low inflation, low unemployment and high budget deficits that amounts to a Ponzi scheme. I estimate that if the UK government has its way with the mini-budget, deficits will rise to 6.5% of GDP in the next couple of years. That is roughly the same as Japan.
But if it worked for Japan for the last 20 to 30 years, why should it not work for the UK?
Remember what we said about Japan – that there is a small chance that running a Ponzi scheme with your government finances will trigger a debt and currency crisis. In Japan, this has not happened (yet) and one key reason is that people need Japanese Yen and cannot simply run away from owning Yen and Japanese bonds. Yes, Japanese bonds are not held by too many foreigners, but, even so, some 14% of all Japanese government bonds are owned by foreigners. That equates to as much as 36.4% of Japanese GDP. Why do foreigners not dump these holdings and create a Japanese debt crisis and tank the Yen in the process?
Well, Japan currently runs a current account surplus of 1.75% of GDP. In other words, it is a net lender to the world and to get that money from Japanese institutions, businesses and households, foreigners need to accept the Japanese Yen. To run away from the currency is tantamount to not accepting Japanese investments anymore, which would hurt the economies of those countries who receive these investments.
The UK, on the other hand, has a significant current account deficit. At the beginning of 2022, it was 2.2% of GDP but it had risen to 4.3% of GDP by mid-2022. As Bill Gross wrote in 2010, “Gilts are resting on a bed of nitroglycerine.”
The UK is a net borrower from the world and relies on foreigners’ willingness to invest in the UK, ‘the kindness of strangers’. Foreigners need to hold Japanese Yen because otherwise they won’t be able to tap into the pool of Japanese investments abroad. But foreigners on average do not need to hold Sterling. The UK is a relatively small part of global GDP and thus can be ignored by investors as part of their portfolio if they think Sterling is not a stable currency. And foreigners don’t need to hold Sterling to tap into a pool of outward investments from UK institutions or to buy British exports because the UK runs both a current account deficit and a trade deficit, making it a net importer of goods and services and a net borrower from the world.
So when the new government in the UK effectively said “we want to go down the route Japan has taken”, foreign investors in the UK answered with “well, we have seen enough. We are not going to participate in this Ponzi scheme”. They sold their Sterling holdings, tanking both the Gilt market and Sterling to the point where the Bank of England had to step in to rescue the Gilt market.
Trying to run a Ponzi scheme with your government finances is possible if people have to hold your currency, which means you have to have a current account surplus and/or your currency has to be the world’s reserve currency. Japan can do that, the US could do that, as could countries like Germany or Switzerland. The UK, Italy, or Greece cannot, though
The way I see it, there are three ways forward for the UK.
1. If the government is adamant about running large budget deficits for a long time, it needs to create a current account surplus. A current account surplus can be created by devaluing its currency significantly to increase exports and reduce imports. That alone will not be enough, though. One also needs to increase domestic savings (good luck with that) or, alternatively, reduce borrowing (which is impossible given that the whole aim of the exercise is to allow the government to borrow more). I have no idea how to increase savings in the UK, particularly in an environment of higher import inflation thanks to a weaker currency. In my view, making the new government’s budget plans work requires two miracles to happen at the same time: i) for UK exports to become internationally so competitive that the UK goes from a trade deficit to a trade surplus; and ii) for UK households to significantly increase their savings in the face of high inflation and a cost-of-living crisis.
2. The second way forward for the UK government is economically very easy, but political suicide for the current government. Simply make a U-turn on all the proposals made on 23 September and accept that like the US, Germany, France and many other countries, the UK needs to focus on low inflation and low budget deficits. A combination of sound fiscal policies and low inflation leads to low growth and less than full employment, but that is the price to pay.
3. The third and final option is to run limited budget deficits and regain the trust of foreign investors that way. If the government wants to foster growth and achieve low unemployment, it needs to push real rates below the natural real rate. This can be done if inflation is allowed to be permanently higher. If UK inflation were to average 4% to 5% while nominal interest rates are held at 2% to 3%, one can achieve full employment and strong growth while running limited budget deficits. The problem with this option is that i) the Bank of England must abandon its 2% inflation target and allow inflation to remain permanently higher, and ii) permanently higher inflation comes with its own costs, not least a weak currency, unattractive equity market returns and rising inequality that could lead to social unrest. I am not sure anyone would like to go down this route.
So, to conclude a very long, philosophical post, in my view the proposed policies of the UK government do not work, cannot work and will not work.
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