If you follow the markets, you have probably heard about the recent financial carnage in Great Britain and the forecasted doom in the United States. While the United Kingdom is a smaller country than the United States, generally speaking the United Kingdom has one of the most profound financial systems in the developed world. Furthermore, the United States and the United Kingdom are the most prominent examples of market-based capitalism in the entire world.
But problems are afoot.
After UK Finance Minister Kwasi Kwarteng announced a series of tax cuts last month, it seems that he and Prime Minister Liz Truss might have cut their careers short, in addition to stoking the fires of budgetary chaos by wayward domestic policy.
In an unusual move, the Bank of England (BoE) warned of dire situations. According to the BBC, “The Bank of England’s warning about financial stability is rare and suggests it cannot confidently ignore the threat it sees to the financial system. It is even rarer for several senior bank executives to have indicated part of the blame for the turmoil may lie at the government’s door, the result of domestic policy. The bank was forced to intervene after government borrowing costs rose sharply despite actions it and the Treasury had taken to calm investors on Monday.”
Additional reporting by the BBC uncovered more concern. It seems the government was “under pressure” from its members of Parliament and had been forced to “U-turn on a plan to scrap the top rate of income tax.”
The Institute for Fiscal Studies warned government departments could see “big and painful cuts” of up to £60 billion a year to balance the books when Mr. Kwarteng announces his economic plan on Oct. 31.
In other words, the strategy was so misinformed that a complete reversal must take place. Until then everyone is holding their breath for Kwarteng’s plan.
The UK economy is already dealing with record inflation, and it is well known that there is an underlying issue of confidence in current leadership. Never mind the fact that the British Pound has been in a dramatic tailspin.
The London-based The Times and The Sunday Times reported: “The Bank of England has announced an emergency intervention in Britain’s financial markets to head off a material risk to UK financial stability” after last week’s budget. In a highly unusual move, the BoE said it would start buying long-term government debt to tackle a surge in the cost of borrowing, which it said risked “contagion to households and businesses.”
The Times continued: “Some of the country’s largest pension funds had warned the Bank that they were facing a cash crisis caused by the unprecedented rise in yields on long-dated government bonds. The Bank also announced it was delaying long-standing plans to begin winding down quantitative easing, which was due to start next week. It follows days of market turmoil that has pushed up the cost of government borrowing and mortgages. Pension funds are under significant pressure. … The Bank said it would start carrying out purchases of long-dated gilts immediately, with the Treasury indemnifying it against any loss.”
Also to blame are low rates—long-term low rates have created a massive vulnerability in the UK’s pension fund market, which adhere to persnickety metrics around a strategy called liability-driven investment (LDI).
Will the Federal Reserve Make More Mistakes?
Meanwhile, problems are developing in the United States: Treasury buyers have pulled back, and the higher interest rates are disrupting the housing market.During a recent live episode of Bloomberg’s “Odd Lots” podcast, Credit Suisse Group’s Zoltan Pozsar said, “Since the year 2000, there has always been a big central bank on the margin buying a lot of Treasurys ... Now we’re basically expecting the private sector to step in instead of the public sector, during a period when inflation is as uncertain as it has ever been. We’re asking the private sector to take down all these Treasurys that we are going to push back into the system, without a glitch, and without a massive premium.”
The Federal Reserve made a serious mistake believing inflation was temporary, only adding insult to injury when policymakers failed to act as inflation in America clearly went through the roof.
Mohamed El-Erian, Allianz’s chief economic adviser, recently stated: “Now we risk the Fed making a third mistake … They are slamming on the brakes this year, which would tip us into a recession …This will go down as a big policy error by the Fed.”
A third mistake by the Fed could be the tipping point. Housing is already stressed as is. The most recent printing of Burns Home Value Index, which measures home-value trends for all homes (new and resale) in 133 markets, shows significant decline on the West Coast, particularly in California, during the past month: Los Angeles declined by 11 percent from its peak; San Francisco declined by 11 percent from its peak; San Diego declined 9 percent from its peak; San Jose declined 8 percent from its peak; and in Orange County, values declined 7 percent from their peak.
Now is probably not the time for to slam on the brakes and cross your fingers that the retreating private market steps in to pick up the slack, while geopolitical tensions are in a serious conundrum, and interest rates are continuing to rise.
Housing aside, it seems like the same thing that happened in the United Kingdom could happen in the United States if policymakers are not careful. Let’s hope the Fed at least escapes making a third fiscal mistake.
Meanwhile, the Biden administration is focused, more than ever, on social justice democracy, the erroneous printing of money, and sending big checks to Ukraine.
That is not much of a recipe for stable fiscal policy.
