As investors assesses the remarkable turnaround in fiscal policy from one of the world’s number-six economy, the U.K., the one conclusion surely is that a nation’s financial flexibility is limited by the willingness of world markets to finance it.
“Ending MMT is the international lesson of the U.K. debacle—any populist selling fiscal pipedreams will be confronted by the precedent of the U.K.,” said Paul Donovan, chief economist at UBS Global Wealth Management, in a recent note.
To which Stephanie Kelton, the leading proponent of modern monetary theory and author of The Deficit Myth replies, “rubbish.”
(Kelton also participates in the Best New Ideas in Money podcast with MarketWatch reporter Charles Passy.)
In a phone interview with MarketWatch, she said the market reaction to the mini budget — of an estimated £45 billion of tax cuts on top of energy price support for two years– was not unreasonable. “Given the expectation that the energy subsidies combined with the tax cuts were almost certainly going to be exacerbating inflation pressure, and that would mean the Bank of England would move even more aggressively,” said Kelton.
What Truss messed up was the messaging, and the lack of coordination with the Bank of England, she said. “You needed to coordinate ahead of time, and message with the Bank of England ahead of time, and have a clearer understanding of market reactions, that initial impulse, may happen,” she said. “But there is a path to getting the budget that she and [former Chancellor of the Exchequer Kwasi] Kwarteng wanted.”
Instead, Truss let the market bully her into submission. “If she hadn’t blinked, guess who would have,” said Kelton, referring to the Bank of England. “There’s no doubt because it’s about financial market stability. It’s not about, so-called fiscal dominance or any of that stuff,” Kelton said.
The pound
GBPUSD,
-1.05%
on Wednesday was trading above $1.12, well above the lows of $1.03 in the ensuing reaction to the initial budget plans that have now been almost entirely reversed. The yield on the 30-year gilt
TMBMKGB-30Y,
3.984%
fell below 4%, after recently reaching as high as 5.17%.
Japan is doing yield curve control, and the U.S. did during World War II, Kelton says. “Any country, any central bank can do it. It’s not a reserve currency thing,” she said.
“It does not follow that if you aren’t the world’s reserve currency, then the bond vigilantes can show up at any time and strip you of your capacity to run the government programs that you want to run,” she added. “You want to give a tax cut, you can give a tax cut. You want to increase spending, you can increase spending. There are potential inflationary consequences and there are potential exchange rate implications. MMT never said otherwise.”
Kelton laughed when asked about the Bank of England’s determination to sell gilts as it fights inflation. “My running joke is, ‘Japan says hi.’” Kelton pointed repeatedly to Japan as an example that the common narrative in financial markets is just wrong. After three decades of deficit spending, the largest debt-to-GDP ratio in the world, decades of quantitative easing and zero interest rates, Japan still can’t get inflation up. “Surely, after a few decades, Japan would have managed to hyper inflate itself.”
Kelton noted a recent speech from Federal Reserve Gov. Lael Brainard, who talked about rising profit margins as a source of inflation. “It’s pretty clear to me that a lot of the inflation that we’re experiencing now is due to companies with pricing power, using the opportunity to raise prices by more than the increase in wages, in energy costs and materials and other things.”
Kelton further asked why the U.K. and other countries are issuing debt at all. “It’s an important question,” she said. There used to be two reasons — during the gold standard, when dollars were convertible, there was only a finite amount of gold reserves. The second reason was the Federal Reserve used to rely on Treasurys for open market operations. But now, there’s no gold standard, and the Fed achieves its interest rate target by paying interest to banks on reserves.
The only purpose these bonds have is for collateral. “It’s a very strange thing that we do, matching the issuance of these securities to whatever happens to pop out of the budget box at the end of the each year, instead of recognizing the real role that they play as collateral,” she said. “And now we’re in the situation where the plumbing freezes up because of requirements, insufficient quantities at single points in time, that then require central bank intervention,” she said.
The conversation turned to Italy, which has a new government but neither its own central bank nor its own currency. Kelton said she “almost had a heart attack” when European Central Bank President Christine Lagarde in 2020 said her job wasn’t to close spreads, a comment the central bank quickly reversed.
Kelton recalls that at the time of the Lagarde comment, the yield on the 10-year Italian bond
TMBMKIT-10Y,
4.756%
was lower than that of the U.S.
TMUBMUSD10Y,
4.125%
On the surface, that made no sense, but in reality it did, because the ECB had negative interest rates and was buying massively to support governments through the pandemic. “I did countless interviews through those two years. And every time a European journalist asks what worries me, well what worries me is when they stop, when they withdraw the support, and let yields go where markets take them. And I’ve been saying that for more than two years.”
