Tuesday, November 29, 2022
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British currency gyrations are about weak government not fiscal deficits – Bill Mitchell – Modern Monetary Theory


The British government has descended into high farce. It is rather embarassing to watch adults behave in the way they have conducted themselves in the last longtime. I also note that the usual suspects are out in force claiming (spuriously) that the economic turmoil that has beset Britain demonstrates categorically that Modern Monetary Theory (MMT) is deeply flawed and the real world is now teaching us that we should be discarded into the dustbin of history – or rather disgrace. These characters, which include so-called progressives think that hard core fiscal rules, like the British Labour Party took into the last election would have saved the day for Britain. I guess they are now mates with the IMF, who in their latest fiscal monitor – Fiscal Monitor – overnight (published October 12, 2022) – called for fiscal restraint. Also, central bankers who met in Washington over the last few days decided they had become the elected and accountable government making gratuitous threats that if fiscal policy wasn’t turned to austerity, they would punish citizens with further interest rate hikes. It is actually hard to find anything of sense in the current economic debate. It is despairing really.

First the Tweeters were Tweeting anti-MMT stuff again over the last few days.

One Tweet, from a former advisor to the Shadow British Chancellor in Corbyn’s Opposition, who seems obsessed with slighting MMT whenever he gets the chance (to reduce his own insecurity no doubt) said:

… You can’t wish away global capitalism, or its national features, because British govt can issue its own currency – this is essence of MMT approaches, we’ve now seen their limits. A radical govt *in particular* needs clear rules and a transparent, well-understood plan.

This is one of many recent claims that the economic turmoil in the UK as well as the global inflationary pressures are evidence that MMT is nonsense.

Apparently, progressives still think that the global gamblers in the financial markets are all powerful and a currency-issuing government can only get away with policies that are ‘approved’ of by these amorphous greed merchants.

That view goes back to the 1970s and earlier and was the basis of the then Labour Chancellor, Dennis Healey lying to the British people about having to borrow from the IMF as a cover for his neoliberal desire to impose fiscal austerity on a nation as he and the Labour Party leadership became increasingly lured by the Monetarist doctrines of Milton Friedman.

It is a view that still dominates progressive politicians around the world – to the detriment of citizens who support them.

And this view is then extrapolated into an attack on MMT, because they misleading claim that MMT denies that private markets can cause economic chaos under certain conditions.

First, MMT doesn’t deny that fluctuations in market sentiment can cause bad outcomes for a nations and challenge government policy settings.

Speculators will form views of what they can get away with when determining whether to ‘test’ the veracity of government policy.

If they think the government resolve to maintain a particular position is weak, then they are far more likely to push currency and bond trades into areas that can lead to a sense of crisis.

They can defeat such a government stance if the government surrenders as we saw on Black Wednesday, September 16, 1992.

I wrote about that in this blog post among others – Options for Europe – Part 51 (March 24, 2014).

The problem then was that the British government had foolishly joined the ERM (a fixed exchange rate system with European nations) and the structural differences between the different nations meant that the system was unsustainable.

The financial markets surmised (correctly) that the system would eventually be unsustainable and Britain would have to leave and float.

They also guessed correctly that the British government would stubbornly try to stay in the ERM as a result of ideological biases within the top echelons of the Cabinet.

Germany was also causally implicated because the Bundesbank refused to help its currency partners through interest rate settings and foreign exchange market interventions.

So the currency was ripe for financial market trades (short selling) and ultimately as long as the Government tried to defend the indefensible (the fixed exchange rate membership of the ERM), these trades would be successful and the currency would fall significantly in value.

The currency stability ended when Britain left the ERM, which is what MMT would have predicted.

Then, the problem was the fixed exchange rate obsession, which was never sustainable and that vulnerability was exploited.

The problem now is somewhat different.

The commentators are claiming that the financial markets didn’t approve of the various fiscal policy changes that the new Prime Minister (is she still in that role!) and Chancellor paraded.

The policies were somewhat crazy in the context although the energy price subsidies were okay.

The mainstream commentariat attempt to say that the financial markets rebelled because they hate fiscal deficits and the Truss proposals were going to push the deficit out further.

But I don’t think that was the issue.

The main issue was that the financial markets sensed the division in the Tory Parliamentary Party and the criticism from all and sundry about the ‘fiscal deficit blowout’ including the terrible Labour Party leadership.

They guessed correctly that the political pressure would eventually cause more political chaos and reversals in policies.

They were right – the Chancellor is gone, the PM is in deep trouble, and the new Chancellor is a fiscal hawk about to introduce policies that favour the rich.

So if the financial markets consider that the government will not stand by its policies they will attack and a weak government will essentially ratify the speculative instability.

That doesn’t mean high fiscal deficits are the reason or that MMT is moribund.

I am fully aware of the ‘power’ of global financial capital.

But equally, I know that a resolute government can see of the financial market bids to undermine it.

I wrote about that last week in this blog post – Zero trading in 10-year Japanese government bonds signals Bank of Japan supremacy (October 13, 2022).

The financial markets tested the Japanese government, the Ministry of Finance which is planning even larger deficits and the Bank of Japan which is wedded to continue its yield curve control, which basically plays the investors out of yield determination.

The Japanese policy institutions stood firm, and the speculators were rendered benign (with losses).

A world away from the political chaos in Britain.

This graph shows the daily exchange rate movements (indexed to 100 on April 19, 2022) for the yen to USD and the pound to USD up to October 10, 2022.

You can see the recent fall in the value of the pound, which in the last week has been somewhat reversed.

Two points:

(a) Both currencies have depreciated against the USD mainly because of the aggressive relative interest rate increases introduced by the Federal Reserve Bank, which has shifted demand towards USD-denominated financial assets (and strengthened the currency).

That has nothing to do with the sustainability of the different fiscal policy decisions.

(b) If anything, the Japanese government’s monetary and policy stance is more offensive to mainstream views than the rather banal Truss mini-budget.

And around the same time that the UK mini-budget was being announced, the Japanese central bank governor reaffirmed its decision to maintain negative interest rates and yield curve control.

Further, the Japanese Prime Minister announced further rather significant fiscal support to ease the cost of living pressures arising from the inflation at present.

So why did the financial markets precipitously sell of the pound and not the yen?

The difference is in the quality of government and the assessment of the speculators on the nerve of the government.

A weak, deeply divided government was always going to swing. The Japanese government knows its capacities and holds its position.

Note also that the Bank of England demonstrated its power against the speculators irrespective of what was happening with the mini-budget reversals.

I wrote about that in this blog post – The last week in Britain demonstrates key MMT propositions (September 29, 2022).

The second related point concerns the claim that some sort of formal fiscal rule would have avoided the currency gyrations in Britain.

I met with his former boss, the MP John McDonnell (in his role as Shadow Chancellor) on October 11, 2018 in London.

I documented that meeting in this blog post – A summary of my meeting with John McDonnell in London (October 11, 2018).

I also wrote this blog post – The British Labour Fiscal Credibility rule – some further final comments (October 23, 2018) – which attempted to summarise the debate.

That post also documents many other posts in the succession of my critique of the fiscal rule concept as normally applied and specific analysis of the so-called British Labour Fiscal Credibility Rule.

The Tweeter was at that meeting with John McDonnell, in the role as his economic advisor. He ‘left’ that position soon after!

As history, regular readers will know that I pointed out in several blog posts that the fiscal rule that the Labour Party had adopted was not only neoliberal in framing but was also unworkable.

The ‘advisor’ and a range of Labour Party lackies who had helped create the ‘rule’ rejected that assessment.

As it turns out, in the lead up to the 2019 General Election in the UK, the Labour Party quietly altered the ‘rule’ and took out bits that I had suggested were contradictory and would lead to them failing to honour their commitments under the ‘rule’.

They couldn’t, of course, acknowledge their earlier mistakes nor apologise for the attacks on me personally and professionally.

Fine.

Underpinning the view that global financial markets can kill the British currency that the Labour Party was propagating, was the claim (at my meeting with John McDonnell) that the UK is a special case because its financial sector is so large relative to the size of the financial sector in other nations.

That specific claim was made by John McDonnell’s then advisor.

The inference was that the fiscal rule was necessary to placate any hostility that might arise in this ‘large’ sector.

I pointed out at that meeting that Australia was a small and very open economy with a significant financial sector as well.

There was disagreement about relative sizes.

Well is as it happens, Sydney and Melbourne are significant financial centres in the world markets.

The following graph gives you an idea of the relative size of the Finance and Insurance sectors in total Gross Value Added in Australia and the Britain.

In relative terms (to size of economy), the finance and insurance sector in the UK is broadly similar to the sector in Australia.

So I posed the question, given Australia has run current account deficits of around 3 to 4% of GDP since 1975 about, and fiscal deficits for much of that time, why hasn’t the finance sector rendered the Australian currency worthless?

The same goes for Japan. It is run large fiscal deficits, has significant public debt relative to its economic size, and has no problem selling more debt to the bond markets whenever it chooses.

Why hasn’t the Australian dollar been dumped given it ran large deficits in 2020 and 2021 and despite attempts to reduce it in 2022, it will remain relative large?

Why hasn’t the yen been dumped and made worthless by these financial markets?

I was told at that meeting that the difference is that the public debt is held by Japanese rather than foreigners and they are running current account surpluses.

So I pointed out the inconsistency.

Japan: current account surplus, debt held locally – no currency dumping.

Australia: typically in current account deficit, debt not held exclusively by locals – no currency dumping.

So all these arguments that somehow suggest the British financial markets are scarier than elsewhere fall by the wayside.

The difference that is palpable, especially recently, the quality of government and the certainty of policy.

The chronic uncertainty in Britain is the standout and that has nothing to do with MMT>

Further, governments abandoned formal fiscal rules mostly around 2020 when the pandemic changed everything.

Fiscal deficits rose variously around the world and government debt increased in line with the practice of issuing debt to accompany the rising deficits.

Why didn’t the financial markets sink currencies in 2020 and 2021 and earlier in 2022?

But think about the logic of the Tweet for a moment.

The latest Office of National Statistics (ONS) revealed that the British government fiscal deficit was £15.8 billion in the first-quarter 2022 which was equivalent to 2.6 per cent of GDP (Source).

In Quarter-2, 20220, the deficit was 27 per cent of GDP (£130.9 billion) as the fiscal support for the pandemic was substantial.

A year later, the fiscal deficit had dropped to 11.4 per cent of GDP (£65.4 billion).

The next three quarters, a significant drop was recorded.

Why didn’t financial markets attack the currency in 2020 or 2021, given that the fiscal position was so significantly at odds with previously stated ‘fiscal rules’ by the Government?

Perhaps the latest instability is nothing at all to do with the fiscal position?

The original ‘mini-budget’ was estimated intending to add £45 billion to the deficit position for tax cuts that would benefit the top-end-of-town.

That would have been about 2 per cent of GDP.

No-one credible believed the tax cuts would achieve the ‘growth’ outcomes claimed.

Further fiscal support of around £60 billion would be offered, some of it for good purposes.

The problem is that policy changes are rarely credible if there is a sudden shift of substantial proportions and size.

Given the circumstances, with supply chain issues and energy prices driving global inflation and demand running a little ahead of the constrained supply, the best thing the British government should have proposed was expanding fiscal support for the poorest British citizens and protecting low-income groups from the inflation.

That would have had a smaller impact on aggregate demand in a time when a rapid expansino in demand was unwise and would not have excited anyone.

MMt does not suggest there are zero fiscal consequences under all circumstances.

But also think about what the Tweeter was suggesting.

The implication is that the ‘absence’ of a fiscal rule provoked the financial markets to attack the pound.

So what sort of fiscal rule would have prevented such a reaction (thinking logically)?

The mainstream commentariat claims fiscal policy has to be supportive (read: subjugated) to monetary policy so as not to undermine the intent of the interest rate rises.

That means fiscal policy should be contractionary if that logic is valid.

This view, of course, doesn’t question the validity of the monetary policy stance, which from an MMT perspective is ridiculous at present given the inflationary drivers on the supply side.

But suspend that for a moment.

If the difference between financial market peace and all out attack is the absence of a fiscal rule, and that rule would have to be proposing austerity right now, given the mainstream logic and the circumstances, then we have a curious position where the progressive commentariat in the UK is advocating the smae position as the IMF.

It is not a position I support.

Conclusion

Same old bunk.

Let’s hope these views are expunged in some way from progressive politics.

Otherwise, there is not much difference between the two major sides in politics in our countries.

That is enough for today!

(c) Copyright 2022 William Mitchell. All Rights Reserved.



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