Don’t give Larry Summers an easy target.
In the immediate (and extremely chaotic) aftermath of Liz Truss’s mini-budget unveil last week, Summers told Bloomberg that parity for the pound wouldn’t be surprising considering the path of fiscal policy. On Monday, at the lows, the pound wasn’t that far away.
“It makes me very sorry to say, but I think the UK is behaving a bit like an emerging market turning itself into a submerging market,” Summers told Bloomberg last week. “Between Brexit, how far the Bank of England got behind the curve and now these fiscal policies, I think Britain will be remembered for having pursued the worst macroeconomic policies of any major country in a long time.”
Fast forward four days and, in a series of tweets, Summers took his criticism of Truss’s economic agenda up a few notches. He also suggested the pound’s problems could pose a systemic risk. His remarks are worth highlighting.
Via Larry Summers
I was very pessimistic about the consequences of utterly irresponsible UK policy on Friday. But, I did not expect markets to get so bad so fast.
A strong tendency for long rates to go up as the currency goes down is a hallmark of situations where credibility has been lost.
This happens most frequently in developing countries, but happened with early Mitterrand before a U-turn, in the late Carter Administration before Volcker and with Lafontaine in Germany.
British credit default swaps still suggest negligible default probabilities, but they have risen very sharply (figure below). I cannot remember a G10 country with so much debt sustainability risk in its own currency.
The first step in regaining credibility is not saying incredible things. I was surprised when the new chancellor spoke over the weekend of the need for even more tax cuts. I cannot see how the BoE, knowing the government’s plans, decided to move so timidly.
The suggestions that seem to have emanated from the Bank of England that there is something anti-inflationary about unbounded energy subsidies are bizarre. Subsidies affect whether energy is paid for directly or through taxes now and in the future, not its ultimate cost.
The magnitude of Britain’s trade current account deficit underscores the seriousness of its challenges. My guess is that the pound will find its way below parity with both the dollar and euro.
I would not be amazed if British short rates more than triple in the next two years and reach levels above 7%.
I say this because US rates are now projected to approach 5% and Britain has much more serious inflation, is pursuing more aggressive fiscal expansion and has larger financing challenges.
A financial crisis in Britain will affect London’s viability as a global financial center so there is the risk of a vicious cycle where volatility hurts the fundamentals, which in turn raises volatility.
A currency crisis in a reserve currency could well have global consequences. I am surprised that we have heard nothing from the IMF.
Did the British pound ever really re-establish itself as a reserve currency after Brexit?
Good job, Larry Summers! He calls it the way he sees it. I agree with him that the state of the pound is sad.
My question is, what’s going on in the mind of Liz Truss and her advisors? Digging the hole deeper is misguided at best. At worst, it suggests delusion.