LONDON – At university in the United States in the early 1980s, I was taught the iconic Mundell-Fleming macroeconomic model, which predicts that a currency’s exchange rate will appreciate in response to an increase in the issuing country’s budget deficit. The Asians, Africans, Latin Americans, and southern Europeans in the room reacted in unison, protesting that it is not like that: any sensible trader will dump the currency of a country whose government is about to engage in massive borrowing.
I was reminded of that discussion as I watched the pound sterling hit its lowest level ever against the dollar, in response to the unfunded tax cuts and spending increases announced by the government of the new prime minister, Liz Truss. The United Kingdom used to be among the countries – mostly rich and highly developed – where the predictions of Marcus Fleming (a Briton) and Robert Mundell (a Canadian who won the Nobel Prize) held true. No more.
Back in school, it took me a while to figure out why the model that is often described as the “workhorse” of macroeconomics did not apply to emerging markets, but the answer is pretty obvious. Macroeconomics for developed countries is all about the present, because one need not worry too much about the future. Back in the early 1960s, when Mundell and Fleming were writing, it was taken for granted that advanced economies would pay their debts, or at least would not rely on inflation to erode their debts’ value. That, too, apparently is no longer true.
Ultimately, a bet on a currency is a bet on the strength of the political institutions that undergird it. Are we to conclude that markets no longer believe in the fundamental solidity of British institutions?
One should not push the point too far. In emerging markets, default risk is the name of the game, and not even the most panic-driven trader is guessing that one day soon His Majesty’s government will formally declare it cannot service its debts. Britain remains a country of formidable institutions. The same palace communiqué that told the world of the queen’s death mentioned that the king and the queen consort would be returning to London the following day. The transition from Boris Johnson to Liz Truss was almost as swift. Regal and democratic power changed hands quickly and smoothly, while the population took to the streets expressing both grief and appreciation. Not many countries can tell that tale.
But even countries with strong institutions face fiscal limits. The tax cuts just announced amount to 2% of GDP. Add to that energy subsidies that could cost £100 billion ($107 billion) in the next year, starting from public debt levels that are roughly 100% of GDP. Until a year ago or so, when zero or negative nominal interest rates prevailed in most advanced economies, this might not have mattered very much. Who cares about debt that has no carrying cost? And when the real interest rate is below the long-term rate of economic growth, a free lunch is possible: higher government spending today need not mean higher taxes tomorrow.
But this is also no longer the case. In response to the fiscal package, the ten-year yield on British gilts surged to 3.77%, completing a rise of more than half a percentage point in a single week. What inflation will turn out to be over that period is hard to guess, but if the Bank of England’s target of 2% holds, the resulting expected real interest rate is 1.77%, which is higher than the British economy’s 1.5% average annual growth over the decade ending in 2021.
If neither default nor sustained high inflation is a likely option, what can go wrong? A lot – and markets know it.
For starters, persistent weakness and volatility in bond prices can damage the financial system, for which the yield on government bonds is the key benchmark. Confronted with such a situation, central bankers find it impossible to look the other way, as European Central Bank president Christine Lagarde learned the hard way in 2020 when she claimed it was not her job “to close spreads” between Italian and German bonds. After the Italian market took a further beating, she had to walk back that comment.
One can also imagine a situation in which fiscal sustainability begins to constrain the monetary authority’s ability to set interest rates. In Brazil, for example, the public debt is both large and short-term, so that every time the central bank tightens monetary policy, the market worries about the government’s ability to pay its bills.
And there is the thorny issue of how long the pound will continue as a major investment vehicle. Asset managers at an insurance company or a sovereign wealth fund in East Asia or the Middle East are sure to keep sizeable chunks of their portfolios denominated in dollars or euros. It is not written in stone that they should hold the currency of a country of 68 million people whose economic output is a small share of world GDP.
Even if such a doomsday scenario never materializes, a fiscal policy that is too loose can still create plenty of headaches. UK consumer prices have risen by nearly 10% over the last year. As the Treasury pumps up demand by spending more and taxing less, the BOE will be busy curtailing demand by jacking up interest rates. The larger the budget deficit becomes, the higher interest rates will have to go to keep inflation in check. In a country of floating-rate mortgages, it could spell financial and political trouble.
Back in the early 1980s, my professor painstakingly explained that in the Mundell-Fleming model, higher government borrowing pushes up local interest rates, which in turn precipitates capital inflows, causing the currency to appreciate. If rates in the UK end up being higher than in the US or the eurozone, the maxi “mini-budget” announced by Chancellor Kwasi Kwarteng could eventually have this effect on the pound. But that is a mixed blessing: Good news for UK importers and Britons vacationing abroad would be bad news for British exporters, jobs, and economic growth.
The problem with a large budget deficit and high public debt is not that they inevitably condemn the pound to being weak or strong. The problem is that they remove degrees of freedom from the conduct of monetary policy, create uncertainty that often spills into private financial markets, make the inflation-unemployment tradeoff more difficult to manage, and can hinder long-term growth.
That is the classic conundrum faced by emerging markets, where it is not unusual to see fiscal and monetary policies working at cross purposes. May God save the UK from that fate.
(Andrés Velasco, a former presidential candidate and finance minister of Chile, is Dean of the School of Public Policy at the London School of Economics and Political Science.