Larry Summers criticizes UK’s ‘totally irresponsible’ fiscal policy

Larry Summers

Cameron Costa | CNBC

LONDON – Former US Treasury Secretary Larry Summers on Tuesday warned that the UK had lost its sovereign credibility after the new government’s fiscal policy sent markets into a tailspin.

The GBP hit an all-time low compared to dollar in the early hours of Monday morning, before a slight recovery on Tuesday, while UK 10-year gilding yield rose to its highest level since 2008 when market downturn on the so-called “small budget” of Finance Minister Kwasi Kwarteng on Friday.

In a series of tweets Tuesday morning, Harvard professor Summers said that while he was “very pessimistic” about the potential impact of “completely irresponsible” policy announcements, he did not expect the market to turn heads. so fast.

“Long-term strong uptrends when currencies go down are indicative of situations where credibility has been lost,” Summers said.

“This happens most often in developing countries but happened with (Former French President) Mitterrand early before the diversion, during the late Carter Administration before Volcker and with Lafontaine in Germany.”

Policy announcements from Prime Minister Liz Truss’s administration last week included an amount of tax cuts not seen in the UK since 1972financed by borrowing and the unflinching return to the “trickle economy” promoted by the likes of Ronald Reagan and Margaret Thatcher. Truss and Kwarteng argue that policies focus on promoting economic growth.

The sudden sell-off in the sterling and UK bond markets has economists predicting more aggressive rate hikes from Bank of England. The central bank said on Monday night that it would not hesitate to act to bring inflation back to its 2% target in the medium term, but would assess the impact of new economic policy at its November meeting. .

Analyst says there is a push and pull between the prime minister and the Bank of England

Summers notes that the UK credit default swap – a contract in which one party buys insurance against a borrower’s default from another party – still proposes a “negligible probability of default”. , but has increased sharply.

“I can’t remember a G10 country that has a lot of risk of sustainable debt in its currency. The first step to regaining credibility is not to say unbelievable things. I was surprised when the new prime minister came out. over the weekend on the need for more tax cuts,” Summers said on Twitter.

“I can’t see how the BOE, knowing of the government’s plans, decided to move so timidly. Hints seem to come from the Bank of England that there is something anti-inflationary about the subsidy. unlimited energy supply is weird. Subsidies affect whether energy is paid for directly or through current and future taxes, not its ultimate cost.”

‘Global Consequences’

Summers, who served as U.S. Treasury Secretary from 1999 to 2001 under President Bill Clinton and as director of the National Economic Council from 2009 to 2010 under the Obama administration, added that the The size of the UK trade deficit highlights the challenges facing the economy. The UK current account deficit at more than 8% of GDPas of the first quarter of 2022 – prior to the government announcement.

Summers predicts that the pound will fall below the equivalent of the dollars and euro.

“I wouldn’t be surprised if UK short-term interest rates more than tripled over the next two years and went above 7%. I say this because US interest rates are currently forecast to hit 5% and The UK has much more severe inflation, is pursuing more aggressively fiscal expansion and has bigger financial challenges,” he said.

Inflation in the UK unexpectedly down to 9.9% in August, and analysts revised their attractive expectations after the government was forced to cap annual household energy bills. However, many argue that the new fiscal policies will lead to higher inflation in the medium term.

“The financial crisis in the UK will affect London’s viability as a global financial centre, so there is the risk of a vicious cycle where volatility affects financial markets. fundamentals, which in turn increases volatility,” Summers added.

“A currency crisis for the reserve currency could have global consequences. I’m surprised we haven’t heard from the IMF.”

His warnings about global spread echo those of US Federal Reserve Official Raphael Bostic, president of the Atlanta Fed, who told The Washington Post on Monday that Kwarteng’s £45 billion tax cuts have increased economic uncertainty and raised the possibility of a global recession. bridge.

Chicago Fed President Charles Evans told CNBC on Tuesday that the situation is “very challenging,” given an aging population and slowing growth, adding that the global economy will need growth. labor input and technology infrastructure to ensure long-term stability. .

‘Emerging market currency crisis’

Sterling has fallen about 7-8% by trade weight in less than two months, and strategists at Dutch bank ING noted on Tuesday that volatility traded for the British pound was “the levels you’d expect during an emerging market currency crisis.”

ING developed markets economist James Smith thinks mounting pressure, likely coupled with comments from rating agencies in the coming weeks, could prompt investors to look for signs of a turnaround. policy from the government.

“Ministers may insist that tax measures go hand in hand with spending cuts, and there are hints of that in today’s papers,” Smith noted.

“We also won’t rule out that the government is taking a closer look at a broader wind tax rate on energy producers, which the Prime Minister has signaled she would oppose. Such a policy would significantly reduce the number of gilded issuances in the coming year.”

The likeness of the UK to an emerging market economy has become more common among market commentators in recent days.

Jim O'Neill Says Bank of England Delays US Fed Policy

Timothy Ash, senior strategist at BlueBay Asset Management, said in a Politico editorial on Tuesday Rising inflation, falling living standards, and a potential wage spiral, countered by tax cuts, will exacerbate already “inflated” budget and current account deficits, and increase public debt, which means the UK is now like an emerging market.

“Predictably, the market has been unconvinced by the new government’s fast-growing economic policy. Government borrowing costs have increased, making their macro projections now look unsustainable. things are unraveling and the crisis is unfolding.” Ash said.

“All of the above sounds like a classic emerging-market (EM) crisis country. And as an EM economist for 35 years, if you’ll present me with principles Based on the above, the last thing I would now recommend is a program of non-refundable tax cuts.”

Bank of England reserves the right not to intervene in the pound's fall, says Howard of GAM

However, not all strategists are sold on the emerging market narrative. Julian Howard, chief investment officer at GAM Investments, told CNBC on Tuesday that the bond sell-off is a global phenomenon and that lower taxes and deregulation could be “very helpful” in the medium term, but the market has “chosen to completely ignore it.”

“I think really what has happened is that the pound and gilts have been caught up in a broader global phenomenon… In the meantime, I think the UK can quietly achieve a growth numbers over the next six to nine months, and that have improved dramatically are ignored,” he said.

“There’s a general inflationary panic going on around the world, and I think if that eases we could see some more stabilization in the UK.”

Howard said talk of an “emerging market” economy was premature and “too harsh”, and suggested the Bank of England should stop raising interest rates any further.

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