This article aims to illustrate what happens to markets and monetary trends when governments take drastic actions that scare investors away. While governments use monetary and fiscal policy to stabilise their economies, a loss of investor confidence can lead to swift and severe consequences as demonstrated by the United Kingdom’s recent economic turbulence under Liz Truss’s government in 2022. Thus, this article also aims to highlight the power that global investors retain over free capital markets and monetary and fiscal policies.
After Truss’ government announced a massive plan to cut taxes and deregulate to stimulate the British economy, investors were shocked by the fiscal expenditures it would require. At a time of already high inflation, economists warned that a positive fiscal policy would only drive prices further upward. Concerned about a potential depreciation of the pound, investors started selling it on the open market, which led to its actual decline. This rapid sell-off of the British currency underscored how sensitive currency markets are to perceptions of fiscal irresponsibility. As a result, as suggested by economic theory, the depreciation of the pound brought some short-term benefits to British exporters and could be positive for the GDP. Theoretically speaking, since the pound was worth less, foreign customers found British goods cheaper, making exports more attractive. However, this advantage was outweighed by the negative impact on the broader economy and the already precarious global economic situation.
Since the United Kingdom relies heavily on imports, the depreciation also meant that imported goods became more expensive for British consumers and producers alike. Additionally, as the pound weakened against the dollar, global commodities, such as oil and gas, which are priced in dollars, became even more expensive for British consumers.
Truss’ government was forced to backtrack on its fiscal plan to avoid further spooking investors. This reversal highlighted the delicate balance between political ambitions and market realities. Even well-meaning reforms can backfire if they are not properly timed or communicated, especially in times of inflation. During inflationary periods, the last thing a government wants to do is empower consumers with more spending capacity, as this can exacerbate rising prices. Even though this dilemma can explain why Truss’ policy initiative scared investors, it is necessary to emphasise that the inflationary pressures in 2021 and 2022 were not entirely due to domestic policies.
The war in Ukraine and the recovery from the Covid-19 pandemic sharply increased prices for gas, oil, and food, adding to the inflationary trend. A more measured approach by the British government, such as providing targeted relief to help taxpayers cope with surging energy prices, could have been more effective without unsettling investors. To restore investors’ confidence and stem the depreciation of the pound, the Bank of England moved to raise interest rates making British bonds more attractive and contributing to a recovery in the pound’s value. This monetary policy response also helped to contain inflation by making loans more expensive and reducing consumer demand. However, an excessive increase in interest rates can drag the country into recession, as it dampens investment and economic activity. Therefore, the Bank of England response had to be carefully calibrated to prevent such an outcome from happening.
The episode surrounding Liz Truss’ government in 2022 is a prime example of the “impossible trinity” or trilemma in monetary policy, a concept that states a country cannot simultaneously achieve free capital movement, a fixed exchange rate and an independent monetary policy. By pursuing aggressive fiscal expansion in an environment of open capital markets, the British government was unable to maintain control over both its exchange rate and monetary policy. When investor confidence faltered, the pound’s value plummeted and the Bank of England had to raise interest rates to stabilise the currency and control inflation. This meant that while the government had control over monetary policy, it was forced to abandon the idea of managing a stable exchange rate. Thus, demonstrating how the three key objectives of monetary policy – capital mobility, monetary policy autonomy, and exchange rate stability – cannot all be achieved simultaneously.
In conclusion, The United Kingdom’s experience in 2022 serves as a clear example of how the power wielded by investors can significantly influence economic stability, forcing governments to reconsider drastic fiscal measures in order to maintain market confidence.
Sources:
– Partington, R. (10.20.2022). “The Mini-Budget that Broke Britain – and Liz Truss”, The Guardian.
– “September 2022 United Kingdom mini-budget”, Wikipedia
-Data from: https://www.bankofengland.co.uk/boeapps/database/Bank-Rate.asp
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