A real-life case study of what not to do
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There have been many lessons learned over the last few years between the pandemic and its economic impact. And the United Kingdom is currently giving us another one.
If you aren't up to date with what is transpiring across the pond, don't worry. There's been so much going on all around the world — it's hard to keep up with everything.
I sat down recently and caught up with most (every day there seems to be something new) of what is transpiring with the United Kingdom. It is a wild economic ride; this situation will be a case study for college students and central bankers for years to come.
What the Government Aimed to Do
The United Kingdom's economy has seen little growth in the last decade plus. Productivity has barely increased and wages have been stagnant.
The UK is a large, established economy that is a net importer.
Liz Truss, the new prime minister, campaigned on the premise of boosting economic growth. She wanted to cut taxes, control government spending, and keep rising energy costs in check.
A few weeks ago, Truss and Kwasi Kwarteng, the finance minister, proposed a new economic plan. It has since sent the economy into chaos.
The plan was to boost the economy, but it did the opposite.
The proposed plan would include corporate tax cuts, reversal of tax increases, and abolishing the top tax rate (45% for earning those more than 150k pounds). The thought was that this would jolt the country into growth.
And it might have done so in normal economic times — but we are not in normal times.
What Actually Happened
The UK, like most of the world, is seeing record inflation. This proposed plan to grow the economy would lead to increased spending, causing more inflation.
This plan put the government at odds with the central bank, which was aiming for the exact opposite. The Bank of England is trying to slow the economy to control inflation; their goal is to have 2% inflation. For reference, the Bank of England forecasts inflation to be 11% by year-end.
An important side note in all this: the Bank of England is independent of the government.
As a result of Truss and Kwarteng's plan, the British pound collapsed. It fell to its lowest value versus the US dollar in history.
Analysts predicted the tax cuts in the plan would cost more than 40bn pounds, causing the government to borrow money. And they would have to do so at the highest borrowing rates in decades.
With the pound losing value, yields on government debt started spiking upward, everyday goods became more expensive to purchase, and there was a worry mortgage rates would rise drastically (most mortgage rates in the UK are variable, not fixed).
In stepped the Bank of England. They "saved the day" by announcing they would set aside 65bn pounds tobuy government debt. This helped stabilize the pound and keep the UK's extensive pension system afloat. Truthfully, I am unsure what the impact of the 65bn purchase will be — but I do not think it will be good.
As a result of the pound losing value and everyone freaking out, Truss and Kwarteng received extreme backlash. This caused them to amend their plan — they would not be cutting the 45% tax for the highest earners. This helped thepound rise in value.
That's the last I've followed on the situation, but there have been other developments. As recently as 10/13, the British government has discussed making changes to the plan. I believe the bill still needs to pass in parliament; I am not sure when the vote is, but I would assume it is likely to pass since Truss' party is the controlling party.
Key Takeaways
It wouldn't be a true economic story if there weren't lessons learned.
This situation shows what can happen when a government and its central bank are planning for opposite scenarios. Truss wanted more growth; the central bank wanted to slow growth; the result was a mess.
For a healthy economy, most times the government and central bank need to be in unison. Speaking now, to what I understand better, the Federal Reserve, like other central banks, is not a part of the federal government. It is supposed to operate independently. But it rarely does.
Another lesson is howpowerful central banks truly are. We've seen that in the last few years as well; their policies impact an unfathomable number of people.
Lastly, we are seeing how dedicated central banks are in the fight to control inflation. The Bank of England wants to control inflation more than they desire to grow the economy.
I'd argue the Federal Reserve is the main culprit for most of the inflationwe are seeing in the US. The Federal Reserve is on a quest to lower inflation by raising interest rates. The Fed has already alluded to the fact that they are alright with people losing jobs in order to achieve "price stability." They will prioritize controlling inflation over almost anything else.
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