How to crash a currency

On the recent tax cuts in the UK

The recently announced £45 billion package of tax cuts  is the largest single fiscal event since 1972, reminiscent of Anthony Barber’s ill-fated Budget. According to NIESR:

• It will lead to positive GDP growth in the fourth quarter of this year, shortening the recession and raising annual GDP growth to around 2 per cent over 2023-24.
• It will increase the government deficit by around £150 billion (roughly 5 per cent of GDP), while we public sector debt is expected to rise to 91.6 per cent of GDP in 2024-25.
• The potential inflationary effects are likely to lead the Bank of England to raise rates more aggressively than previously expected. The NIESR now expects the Bank rate to peak at around 5 per cent in the third quarter of 2023.
• Low-income households, which do not qualify for tax credits, pension credits, legacy benefits or Universal Credit, will receive financial help that falls short of the increase in energy bills (nearly £2,000) and in food bills.

An Independent Assessment of the Mini-Budget
By: National Institute of Economic and Social Research

What could have driven the drop in the pound’s value

According to Menzie Chinn, the reaction of financial markets indicates a lack of credibility, insofar as the promised results will actually occur.

The drop in the pound’s value against the US dollar is counter-intuitive (at least to me) for a country with government bonds that would be perfectly substitutable with say US government bonds — i.e., a situation where uncovered interest parity would hold. However, if bonds are not perfectly substitutable, then one could resort to a portfolio balance model. The simplest version would indicate a large expected increase in bond supply would then lead to a depreciation of the currency. And that is exactly what we have seen. While the parameters of the so-called mini-budget are not too different from anticipated, it seems that the announcement of two  [reduction of the top income tax rate by 5 percentage points from 45 per cent to 40 per cent and  reversal of the planned increase in the Corporation Tax Rate from 19 per cent to 25]— rather than one — tax cuts in the context of already big budget and trade deficits is eroding credibility.

Weekly Economic Activity in the UK, and Two Self-Inflicted Wounds
By: Menzie Chinn – University of Wisconsin-Madison

How will the Bank of England react?

From Thorsten Beck:

The Bank of England as independent monetary authority has stayed calm (in good English tradition?), but their statement on Monday evening suggests that it might be reluctant to raise interest rates too quickly in an attempt to off-set the pressure on the British pound that the fiscal expansion has caused. Another clear example that the independence of central banks has its limits in a country with no written constitution and where the previous government has trampled over long-standing norms and customs thus undermining the same institutions that are now so urgently needed. Either way, the bill for the reckless fiscal expansion will be paid by a large majority of the British population in the form of higher inflation (due to the depreciation and thus higher import prices) and/or higher interest rates translating into higher mortgage costs. What a way to run/ruin an economy!

From Simon Wren-Lewis:

It’s very unlikely we will see a repeat of the Barber boom of the 1970s for two reasons. First and most importantly because we now have an independent Bank of England. Instead what this budget ensures is higher interest rates. […] The second reason we will not get anything like a Barber boom is that most of the tax cuts are going to the better off who save most of their extra money.

What a week! And it’s only Tuesday
By: Thorsten Beck -European University Institute
A budget that harms everyone except the very rich
By: Simon Wren-Lewis – University of Oxford