Aurelia Butler

Here is how the script used to go. South European countries suffer from chronic political instability, have weak public finances and have given up their own currency, so financial market meltdowns are just waiting to happen. The UK, in contrast, has retained its currency and knows how to manage markets, so it has both more room for manoeuvre and the skill to navigate it better. Surely the past week must have convinced the last true believers to bin that script. Italy had an election that put far-right Giorgia Meloni in a position to lead a new Italian government that will be a mix of inexperience and the very wrong kind of experience. Yet it was the UK’s new government that triggered a financial market panic with the mini-Budget presented last Friday by Kwasi Kwarteng, the UK’s new chancellor.The opposite has transpired. Not that Italians got off scot-free: as of Wednesday night, Rome’s 10-year borrowing costs had risen by 0.5 percentage points since last Thursday morning, with the increase peaking at 0.7 points a little earlier. Government bond yields have risen elsewhere too. But the UK’s 10-year gilt yield jumped 1.2 percentage points in just a few days. It was only after a dramatic intervention by the Bank of England that the increase moderated to 0.7 percentage points on the week. The pound fell too, dropping to record lows against the dollar. That is a poor indicator, however, because the dollar has been “smashing almost everything in sight”, as Robin Wigglesworth puts it, including the euro, which now trades well below parity. Still, the pound has lost about 3 per cent of its value even against the euro since last Friday morning.Above all, there was real disruption where the financial markets meet the real economy: hundreds of mortgage products were abruptly withdrawn, and pension funds suddenly found themselves squeezed as plunging government bond prices wreaked havoc with their balance sheets. That was the prompt for the Bank of England’s intervention (on which more below).So in a comparison with Italy, the UK comes off worse if judged by many financial market metrics. That is not what Friday’s statement by the chancellor was supposed to achieve. On the contrary; this was the occasion to set out a “growth plan” that was supposed to show how a Brexit Britain could be run differently from the EU model it had thrown off. What happened?The most-told story is one of borrowing pushed too far, and lenders pulling out — what Brad Setser calls an external funding crisis, and once seen as a risk to the US brought on by its combined fiscal and current account deficit (sounds familiar, UK?). If the British government just went beyond what financial markets thought was sustainable, higher borrowing costs and a weaker pound were to be expected. In other words, a sort of balance-of-payments crisis and government-funding crisis combo, just the kind of problem many have blamed on the euro in the past.Another, not mutually exclusive, explanation is that the mini-Budget’s fiscal stance is inflationary, to an extent that the BoE will struggle to offset, either because it is loath to tighten enough or because the government will pressure it not to. Market fear of such “fiscal dominance” would also naturally lead traders to sell off both UK government bonds and the pound. But I am sceptical. First, there is no sign that inflation expectations actually increased in response to Friday’s mini-Budget; indeed, on some market-based measures they have fallen. But, second, it is a central problem for both explanations that the mini-Budget contained hardly any news at all. In the days before the mini-Budget, the excellent Institute for Fiscal Studies produced public finance projections based on what press reports said would be in the announcements, which turned out to be almost spot on. Both the fiscal stance and the debt implications were well absorbed by markets before the chancellor gave his speech.The one “rabbit out of the hat” policy was to abolish the highest rate of income tax, which will make very rich people quite a bit richer but only loses the government a few billion pounds in annual revenue — not enough to move the needle for those assessing governments’ creditworthiness or really for the BoE’s interest rate calibration. In a research note, Nomura’s Europe economists put the cost of previously unknown policies at a modest 0.25 per cent of gross domestic product on average for the next five years.The fact that any vandalism to the economy or the public finances was already well known makes me hesitate to attribute the panic to the content of the mini-Budget. It also makes me hesitate about a widely held view that the panic will continue or worsen unless the government reverses course on its tax cuts or sets out a package of spending cuts to pay for them. (This hesitation is, of course, also informed by my view, not shared by many, that the overall macroeconomic stance is tightening too much everywhere, and that we should treat accumulated debt with benign neglect.)Nomura’s conclusion seems closer to the mark. The huge market reaction, its analysts think, was “not because the chancellor did a lot more over and above what he said the Treasury would do, but rather because it signalled ‘intent’ for potentially further policy easing ahead and a lack of deference to the UK’s fiscal police (ie, the Office for Budget Responsibility)”.More tone than content, in other words. As Robert Shrimsley reminds us, the new government is the latest (and, so far, perhaps the purest) incarnation of the movement that produced Brexit, which has proved itself perfectly willing to cause economic damage and undermine Britain’s institutions, while denying any such thing and deepening political polarisation in the process. So maybe it was just that the statement finally convinced investors and financial traders of the government’s pigheadedness. It exposed the country’s leaders as ignoramuses who have drunk their own Kool-Aid and genuinely believe growth will come from policies that have neither “evidence nor experience” in their favour, as Minouche Shafik lays out perfectly in an FT op-ed, and as John Van Reenen does in a blog. It also demonstrated a willingness to plough on with a politically destabilising programme — this profile of Kwarteng is instructive in that regard. The talk is already of whether the Conservative party will let the chancellor or even the prime minister herself survive — which, in turn, can’t be good for the economy. Simply put, Kwarteng’s “plan for growth” announcement convinced most sensible people that the UK’s growth prospects just got worse. Markets got to know the attitude behind the policies, and didn’t like what they saw, explaining a generalised sell-off. In a sense, the Brexit bunker mentality is right: everyone else is “woke”, insofar as “woke” means thinking that growth relies on investment, a functioning state and political predictability. What all this implies is that there is no way back. We should see the market panic as a correction; a one-off adjustment of prices that were mismatched to the nature of the current government. Things could well stabilise at this new level, and neither return to previous values even with a policy change (because markets would not unlearn what it has learnt about the new government) nor get worse without one. We are where we are.Instead, this episode raises some other hard questions, especially for the BoE.Like its counterparts elsewhere, the central bank is set on a course of raising interest rates significantly. In the past week, markets have done a lot of the job for them. The results show that those who think they should have tightened more and faster should be careful what they wish for. The sharp rise in UK mortgage costs is just one illustration of the pain monetary tightening was always going to entail. More and more will be asking whether this is really what the economy needs. The BoE struggles to communicate what it now wants to do. Its chief economist has signalled that the market panic calls for further tightening. But it was open to the bank to say the opposite: precisely because the market had strongly tightened financial conditions of its own accord, the monetary policymakers could hold off for some time. The problem here is that the BoE leaves it unknown (and may, in fact, not know) which market financial conditions — long-term gilt yields, say — are appropriate for the economy. It does not help that UK fiscal policy is now explicitly at cross-purposes with its monetary policy: the Treasury seems to be aiming for a looser overall macroeconomic stance than the bank. That is the opposite of macroeconomic policy co-ordination.And all of that comes before the breakdown in the gilt market that forced the BoE to intervene on Wednesday. The short story is that as gilt yields rose abruptly, pension funds that had hedged against interest rate changes were forced to present more cash as collateral to their counterparties, which they could only get by selling gilts, thereby fuelling a spiralling sell-off. (For more details, read Alphaville’s explainer.) As Timothy Ash points out, this was a disaster waiting to happen. If the financial market cannot absorb a fast rise in rates without risking serious disruption, that poses two questions. Why did regulators permit this situation to develop — is it worth letting pension funds take these (in normal times small) risks? And what does it mean for the central bank’s ability to raise rates as the macroeconomic situation requires?To be clear, the central bank was certainly right to intervene to buy bonds and stabilise the situation. But having announced it would start selling bonds last week, only to start buying them again, while promising to start selling in a few weeks’ time, is confusing at best and contradictory at worst. If this means our financial systems can’t cope with certain monetary policy paths, we have a problem. And it’s a problem that applies much more widely than in the UK. Remember that a similar “dash for cash” caused a sell-off in US Treasuries two years ago, and that similar pressures are present in US Treasury markets today.All this points to deep incoherence, or at least unpreparedness, for the monetary tightening cycle most people are telling us we need. If financial markets are so sensitive to moves in longer-term government bonds, then why should central banks not focus more on controlling those rather than the short rates? We know two things. First, that if monetary policy controlled long yields, changing them gradually as the macroeconomic picture required, this week’s UK pension funds debacle would not have happened. Second, that central banks can choose to target long rates: the Bank of Japan has, for years, demonstrated how. Other central banks have adopted Japanese policies before. It seems time to consider doing so again.Other readablesPew Research documents show how the rest of the world increasingly takes a negative view of China. In response to my recent piece on expectations and beliefs, the IMF’s Fuad Hasanov shared an essay on narratives in policy choices for economic growth.The International Telecommunication Union is choosing its next secretary-general — and if that doesn’t interest you, it should.Numbers newsFour-fifths of producer price inflation in Europe can be attributed to supply-side factors rather than high demand.The European Bank for Reconstruction and Development projects higher growth in central Asia and the Caucasus, even as Russian president Vladimir Putin’s war on Ukraine devastates economies elsewhere. One reason is that the region has benefited from new transport routes in response to sanctions on Russia, as this article explains. More

The writer is director of the London School of Economics and Political Science and a former deputy governor of the Bank of EnglandThe government’s recent fiscal plan fails to respond to the UK’s twin economic crises in a manner that takes into account either evidence or experience. While they are absolutely right to focus on cushioning the shock of the skyrocketing cost of living and trying to stimulate growth, the policies they have outlined do neither well. The market’s extreme reaction to the “mini-Budget” reflects the fact that the government has not told a credible story about its economic strategy.The UK economy has two urgent problems. The first is a cost of living crisis fuelled by dramatic shifts in the supply and demand for goods — particularly energy — in a time of war, plague and other trade disruptions. The second is more than a decade of low growth and productivity, or what the Economy 2030 Inquiry memorably calls “Stagnation Nation”. With the highest inflation rate in the G7, growth in labour productivity well below the OECD average, stagnating real wages since 2010 and a host of other terrible economic indicators, it is no surprise that the Bank of England projects British households are facing the biggest collapse in living standards since such records were first kept 60 years ago.We should let the BoE get on with doing its job of raising interest rates to fight inflation. This is not the time to do anything that might undermine central bank independence, which has delivered the low and stable inflation that we have all benefited from. A massive fiscal expansion and a collapsing pound just make the BoE’s job harder and will mean that interest rates have to rise even more to control prices.In a good society we should provide the greatest cushion to those who need it most. The energy price cap is a very expensive response (to the tune of about £100bn) that provides support to many that do not need it and reduces incentives to make progress on climate change. Instead of a cap, the government should provide a universal lifeline tariff for energy consumption up to a certain level to protect the poorest households and small businesses, and let those who consume more pay a market price. This would cost less, help everyone and maintain incentives to use energy more efficiently.When it comes to stimulating growth, we need a serious plan to deal with the chronic under-investment that is the cause of Britain’s stagnating productivity. Despite many years of economists’ time devoted to the productivity puzzle, it is becoming clear the answer is pretty simple — chronic low rates of investment by both the public and private sectors. When I was at the World Bank, we did hundreds of investor surveys on what determined their willingness to invest in a country. The top reasons were almost always the same: first came macroeconomic and political stability (which has been put into jeopardy in the UK), high-quality infrastructure and skills. Low taxes and enterprise zones were always near the bottom. The key to growth is to create an environment where there are great commercial opportunities — tax rate differences of a few percentage points are largely unimportant if you are making a lot of money.A better policy response would be to use any remaining fiscal space to invest in a serious productivity agenda. This would include mechanisms for increasing investment in infrastructure, skills, research and innovation, alongside incentives to firms to adopt technologies to increase productivity and achieve net zero targets. A £100bn investment in those areas would be transformative for the UK and have far more impact than the same amount in tax cuts to high earners and corporations. Markets would react a lot more favourably as well.

The government is right about another thing — redistribution is not a panacea. A better option is to invest in people so that they can earn decent wages in the labour market — what economists call “pre-distribution”. The current policy proposals are actually doing quite a lot of redistribution (in favour of the rich) in the hope that some of it will trickle down. A much better alternative is to invest more in pre-distribution — early years education, adult learning, research and innovation and infrastructure, especially in deprived areas. That way everyone has a chance at a decent standard of living.The current proposals are bad economics. They are also a lost opportunity that will close off options for the future. A better option would address the short-term energy issues more efficiently while using this crisis to deal with the longer-term productivity problems facing the UK so that the economy can grow, deliver good living standards for all and continue to make progress on tackling climate change.  More

Sean Hagan was general counsel of the IMF from 2005-2018; he is currently professor from practice at Georgetown LawOver the years, efforts to improve the sovereign debt restructuring process have focused primarily on addressing collective action among private creditors. That has changed. There is now a consensus that a key obstacle to this process — including the process launched by the so-called “Common Framework” — is securing co-operation among official creditors, with much of the focus being on the largest among them, China.Opinions vary as to the changes to the international architecture that are needed to address this problem. But I think that greater attention should be placed on a consistent application of the existing framework. More specifically, the major shareholders of the IMF should simply support a robust application of its lending into arrears policy.The relevance of the IMF to this debate is not surprising. The IMF has always played a central role (for better or for worse) in guiding the debt restructuring process. A country will typically only initiate a debt restructuring if and when the IMF determines that it is no longer prepared to provide financing in the absence of a restructuring. Moreover, when a restructuring is needed, the financial parameters of an IMF-supported program determine the overall amount of debt relief needed to restore debt sustainability. A key challenge has always been the next step: ensuring adequate creditor co-operation. On the one hand, the IMF is reluctant to postpone approval of financial support until the ink is dry on the restructuring agreement. On the other hand, it cannot approve a program until it has adequate assurances that creditors will, in fact, provide relief consistent with the program’s assumptions.The IMF’s approach to obtaining these assurances from creditors (generally referred to as its “financing assurances” policy) has evolved. During much of the 1980s debt crisis, IMF would not approve a program unless a critical mass of private creditors signalled their willingness to provide the necessary debt relief. However, over time, creditors began to drag their feet and, as a consequence, the IMF found its financial support for countries being unduly delayed.The IMF therefore introduced one of its most consequential policies — the “lending into arrears” policy: in the absence of creditor support, the IMF obtained financing assurances by assuming that if — during the period of the program — the debtor failed to reach an agreement with its creditors, the necessary financing for the program would be obtained through the accumulation of arrears.A key aspect of this policy is that it can be relied upon even when arrears do not exist — in other words, in a pre-default context. In these situations, the financial parameters of the program assume that payments will no longer be made in accordance with the original contractual terms. While the first best scenario is that these parameters will be observed through a consensual restructuring that avoids a default, the IMF can proceed on the basis of an assumption that, even in a worst-case scenario, these parameters would be observed through the accumulation of arrears. In essence, the policy can be used as a backstop.Unsurprisingly, the introduction of this policy was unpopular with private creditors: they no longer had the leverage to hold up an IMF program. Moreover, in order to avoid a default, they had no choice but to provide debt relief on terms consistent with the IMF’s program.As originally conceived, this muscular approach was limited to private creditors. Through the Paris Club process, bilateral government creditors continued to provide early assurances to the IMF regarding their willingness to provide the necessary debt relief on a consensual basis. However, over time, exclusive reliance in this consensual approach broke down with the emergence of new official bilateral creditors who were unwilling to join the Paris Club, including China. Faced with this challenge, the IMF decided in 2015 to adopt a policy enabling it to lend into arrears to official bilateral creditors.Importantly, the policy on official arrears is less flexible than the one applicable to private arrears. Although two of the criteria that must be satisfied also apply to private arrears (namely, the urgency of IMF support and the existence of good faith efforts by the sovereign), the third criterion is specific to official claims: the policy cannot be applied if it would have an “undue negative effect on the Fund’s ability to mobilise official financing packages in future cases”. Because arrears on a particularly large creditor — or group of creditors — increases this risk, the policy provides that the Fund would “normally” not be willing to lend into the arrears when the total value of claims held by the official creditor(s) in question represented a “majority of total financing contributions required from official bilateral creditors over the program period”.Notwithstanding these constraints, the 2015 policy remains an important policy tool, both in the pre-default and post-default context. In particular, the term “normally” provides flexibility and could, consistent with the policy, enable the IMF to lend into the arrears of a large creditor that does not have a proven record of providing debt relief. Unfortunately, the IMF has generally been reluctant to apply this aspect of the policy. This reluctance no doubt reflects concerns at the IMF Executive Board, where the interests of traditional Paris Club creditors are represented. There may be a worry that even if a country accumulates arrears to a large official creditor during the program period, the creditor in question will be able to use its influence to restore the full value of the claim upon the expiration of the program, raising both sustainability and inter-creditor equity issues. While this is no doubt a risk, there may be ways to mitigate it, including through the type of “Most Favoured Creditor” provision recently suggested by Lee Buchheit and Mitu Gulati.In any event, this reinstatement risk must be weighed against another one: giving a creditor a veto over the approval of an IMF program. This is precisely the risk the lending into arrears policy was designed to address.  More

After a meeting between Biden and his administration’s top economic officials, the White House said in a statement that his advisers had told him the U.S. economy remained “resilient in the face of global challenges.” “The President directed his team to stay in frequent touch with partners, allies, and key market actors, and to brief him regularly as conditions evolve,” it said. More

TOKYO (Reuters) – Sterling retreated again on Thursday from a sharp bounce against the dollar overnight, after the Bank of England announced unlimited bond purchases to shore up Britain’s financial markets battered by the government’s radical plans to cut taxes.The UK currency jumped the most since mid-June on Wednesday, pulling the euro with it, after the BoE conducted the first of its emergency bond-buyback operations, worth more than 1 billion pounds. It committed to buying as many long-dated gilts as needed until Oct. 14.Sterling was 0.51% lower at $1.0831 as of 1200 GMT, returning some of the previous session’s 1.41% rally. The euro weakened 0.32% to $0.97065, following Wednesday’s 1.51% surge, the biggest since early March.Sterling had plummeted to a record low of $1.0327 on Friday as investors delivered a scathing verdict on the new government’s plan for record tax cuts funded by a massive increase in borrowing, at the same time as the BoE is aggressively tightening monetary policy to rein in rampant inflation.Europe’s shared currency had plunged to a new two-decade low of $0.9528.”The BoE’s bond purchases may temper the UK government’s borrowing costs but have not resolved the tensions between fiscal loosening and monetary tightening,” Carol Kong, a strategist at Commonwealth Bank of Australia (OTC:CMWAY), wrote in a client note.”Concerns about the UK’s fiscal plan and its broader economy suggest GBP will likely stay offered against the USD and other major currencies in the near term.”The U.S. dollar index, which measures the greenback against sterling, the euro and four other major peers, edged 0.07% higher to 113.11, heading back in the direction of Wednesday’s 20-year high of 114.78.The dollar added 0.23% to 144.43 yen. The currency pair has kept its head below the 145 line since Japanese officials intervened a week ago, following a surge to a 24-year high of 145.90 that day.Elsewhere, the risk-sensitive Australian dollar sank 0.38% to $0.64995, giving back some of Wednesday’s 1.34% climb.New Zealand’s currency dropped 0.42% to $0.5706, following a 1.7% surge in the previous session. More

In a speech at Stanford University, Malpass said there was an increased likelihood of recession in Europe, while China’s growth was slowing sharply, with grave consequences for developing countries.Addressing the current “perfect storm” of rising interest rates, high inflation and slowing growth – and undoing the reversals in development required new macro- and microeconomic approaches, Malpass said. More