Two weeks ago, the United Kingdom held a state funeral for its monarch that showed off the dignity and grandeur of history’s most politically and economically successful constitutional monarchy.
Last week, it bumbled into the league of banana republics.
The International Monetary Fund – the global institution whose job it is to shore up wobbling countries’ finances and protect the world from financial calamity – saw fit to rebuke Britain for the egregiously ill-conceived “growth plan” it unveiled 10 days ago. (In brief: massive tax cuts, massive borrowing.) The IMF urged the government to “re-evaluate” the wisdom of a huge and costly fiscal stimulus, at a time when British inflation is north of 8 per cent and the Bank of England is aggressively raising interest rates to cool soaring prices.
Not that we needed the IMF to tell us that this was a bad idea. The financial markets had already come to that conclusion, rapidly and with great conviction.
In the span of just three days, the yield on Britain’s 30-year government bonds (or gilts, as they are known) spiked from 3.78 per cent to 4.99 per cent. The pound sterling lost nearly 5 US cents to the U.S. dollar in a single day. As the crumbling markets triggered margin calls on British pension funds, fears escalated that some funds would be squeezed toward insolvency.
Last Wednesday, the Bank of England stepped in with an emergency pledge to buy up to £5-billion (roughly $7.5-billion) a day of long-term gilts until the middle of October, in the name of stabilizing the fast-failing market and staving of a full-blown financial crisis. That’s up to £65-billion in just 13 trading days.
It’s the kind of extraordinary action that central banks take in response to some sort of major, unpredictable external shock – a pandemic, perhaps, or a war – that sends markets into dysfunctional, panicked convulsions. In advanced industrialized economies with sophisticated finances and well-formed institutions, the cause is not typically the hairbrained economic schemes of one’s own government.
Did the markets overreact? Sure, probably. By the end of last week, with the Bank of England’s reassuring backstop in place, the 30-year gilts had fully reversed their selloff and yields had returned pretty much to where they were before the government announced its plan. The pound, too, had recovered most of its losses.
But let’s not kid ourselves that this can be isolated as a “U.K. market” or “overseas market” hiccup; the government bond market is very much a global beast, and the reaction in gilts was certainly an international reaction. Britain’s missteps have put the world’s financial system on notice.
The jarring week demonstrated just how little tolerance the markets have right now for fiscal policy experiments and government wingnuttery. They’re having enough trouble trying to absorb the ever-rising expectations for central bank interest rates. But at least the application of monetary policy is pretty standard and well-understood stuff, even if the trajectory is out of the ordinary. Loose-cannon government policy presents a whole new level of instability; markets have sent a powerful warning that they have no stomach for it.
This also demonstrates how easy it is to complicate the already difficult job that central banks face in trying to stomp out inflation. The fiscal policy faceplant has essentially forced the Bank of England to reverse course on unwinding its pandemic-period quantitative easing program, at least temporarily. If the government doesn’t reconsider its stimulus package, the effect will certainly be inflationary – likely forcing the Bank of England to raise interest rates even further. Monetary policy now stands starkly at odds with fiscal policy.
Mind you, the British had already created the groundwork for this failure of market confidence well before the government announced its plan. Brexit – another dreadful idea – had already placed a massive weight on the back of the British economy. There’s a reason why Britain is the only country in the G7 whose GDP hasn’t yet recovered to its prepandemic levels. It’s a self-inflicted wound.
There is a lesson here for any leaders – including those in Canada – tempted to stray too far from the beaten path in their attempts to address the public unrest that has emerged from the pandemic. When the likely next premier of Alberta, Danielle Smith, promises to unilaterally declare the province’s sovereignty to override federal laws, or when federal Conservative Leader Pierre Poilievre embraces cryptocurrency and promises to fire the head of the Bank of Canada, they are putting whiffs of instability into the nostrils of the markets. As the British could tell them, it’s a dangerous game.
Mr. Poilievre seems to have toned down those messages as he has evolved this year from Conservative poster boy to within an election of the Prime Minister’s Office. What he has not backed away from, however, is a mantra of lower taxes.
Let’s hope he’s been paying attention to Britain in the past week. Tax cuts may be sweet candy to voters, but markets will take a very dim view of reckless vote-buying until the Canadian and global economies are on more stable footing, and central banks are in less of a fevered rush to tame inflation. The past week has shown that if you gamble away the markets’ confidence, there’s a high price to winning it back.
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