The Return Of The Bond Vigilantes: Or Great Britain As An Emerging “Emerging Market”
One of the hardest aspects of our self-imposed regulatory purdah over the last 6 weeks has been not being able to write and share more about what has been occurring in the United Kingdom.
It was very hard!
As you probably know, a new Conservative Prime Minister, Liz Truss and her Chancellor released a new "mini Budget" plan for the UK that promised to slash taxes and regulation in an effort to boost growth.
The basic concept - rekindle growth - was right but everything else was wrong: It was a poorly timed and poorly framed package that was also unbalanced in the sense that it pushed directly against the actions of the Bank of England.
Cutting taxes when you are raising interest rates to combat inflation doesn't make a lot of sense but that was only the beginning of the nonsense. We will talk about it a few different ways over the next few editions.
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The Truss plan always going to be met with real skepticism and likely a negative market reaction but its clumsy communication and unexpected arrival did far more damage than that.
In fact, these proposed measures rapidly launched a full blown panic in the British currency and bond markets that kept escalating until it brought the country to the very brink of a financial crisis.
That was obviously very bad.
It isn't necessarily over but it has been covered to death.
But while that is still true, we nonetheless believe that there are two quick and interlinked points to make that haven't been beaten to boredom.
The key problem for the UK is simply that the markets have now begun to refuse to accept more unfunded fiscal spending or in this case, tax cuts.
The second is that the situation in the UK may be a result of its own unique predicament but there is zero reason that a similar general outcome cannot happen elsewhere.
Let's dive in:
The big takeaway is deceptively simple:
Deficits do matter. Debt does matter. How you structure your economy and society does actually matter quite a bit. Investors can and will say: no mas.
We seem to have forgotten this. Or a lot of our political class and commentariat have. Over here at the Pebble HQ we have carefully tended the flame of common sense consequences all along.
The rapid (and negative) market reaction to the Truss proposals and the subsequent equally rapid reversal of most of those policies was something that the developed rich world hasn't seen in decades - the return of the bond vigilantes!
Endless giveaways and reckless spending on the left - or unequal tax cuts for the rich and corporations on the right - can and will be punished.
This is especially the case for the United Kingdom of Great Britain and Northern Ireland that runs a (large) current account deficit. They rely on foreign inflows to fund their expenditures - every quarter.
This isn't small either. In the UK's case it was around 32.5 billion GBP or 5.3 % of gross domestic product in the second quarter of this year.
What has changed?! Why are investors - and especially bond investors - suddenly back in the driving seat.
Good question. This is really the key aspect to remember.
And the answer is that:
The central bank, the legendary Bank of England, isn't able to act as it has in the past.
This touches on a point we have made before: inflation has made the "business as usual" of the last decade+ no longer possible. The old status quo is toast.
Why?
Well, the Bank of England is busy fighting inflation and cannot stimulate the economy and increase top line growth. It has to raise interest rates, not cut interest rates.
Put differently: the central bank is out of the fight and on the sidelines. The new Conservative government didn't get the memo. It was trying to stimulate the economy fiscally while the Bank of England was attempting to tighten monetary conditions.
This brings to mind the old-but-still-brilliant Far Side cartoon:
And this is where we reach the second of our above two points:
It is highly unlikely that the UK will be alone in experiencing this discipline from financial markets.
Make no mistake about it, the British present could be your future.
Rather, inflation has taken away the ability of central banks all over the world to bail governments out from their mistakes or simply ease financial conditions to overcome temporary and unforeseen events.
The UK isn't the exception, it is just the most unlucky and poorly governed portion of the rule.
This answers one of the complaints from some (narrow minded American) circles that all of this present focus on the UK is sort of a boring financial sideshow from a smaller economy that is becoming smaller still and there are other, more important stories to focus on.
But away from the car crash voyeur aspect of the whole disgraceful Truss-Karteng mini Budget debacle there is an important truth that we should be paying great mind towards.
This could be us. Or it could be you.
The old status quo is dead for everybody, not just Old Blighty.
Therefore, other nations and policymakers should be watching the United Kingdom with great caution. The phrase "there but the grace of God goes I" should be ever present in our minds.
Now, this state of affairs could change. Perhaps developed central banks won't be allowed to be as independent as they are in the future and will have to cut rates. For instance, Turkey's President is effectively in charge of the central bank these days and is totally convinced that the answer to high inflation is interest rate CUTS, not HIKES.
The Turkey central bank just cut interest rates for the 3rd month running - Turkey has an inflation rate of over 80%. Sounds fun.
Or perhaps inflation will come down and strong economic growth will allow us off the hook.
But it is very unlikely that it will over the short to medium term. For convenience sake let us say over the next year or so.
And so here we are.
The end result for the United Kingdom is clear:
It is becoming a poorer country.
We said this earlier this year about some of their earlier policy blunders and it is striking to us that, despite the endless coverage and reams of tweets and op-eds and talking heads, this core fact somehow seems to get lost in the shuffle.
For reference, in 2016, the UK's economy was 90% the size of Germany's. Now it is 70% and almost certain to fall further in the quarters ahead. Blah blah, they are different populations and the per capita size is less stark etc all of which is true but net-net that is quite a precipitous drop in under a decade.
The newly enthroned King Charles III might point out that there is more to life and happiness than GDP growth to which we would point out:
He lives (and writes) in a palace.
Some of his subjects are waiting two years for standard medical operations, the overall wait lists have hit 7 million and are dying in ambulances in the forecourts of the NHS hospitals.
Sliding clumsily towards being an emerging market is no fun and being a quantifiably poorer country has consequences. Economic growth might not be everything but it is important nonetheless.
And in the end, this is the most important conclusion to glean from the British coverage. The United Kingdom is impoverishing itself and doing it through its own agency and choices. As with our issues over baby formula, we can't blame exceptional circumstances or outside forces.
Your decisions do matter. And we shall return to this theme in next week's as well and do so through the lens of the US.
And make no mistake about it, there are some interesting developments on the American front as well.
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