A stinging zinger aside, the gear’s performance is no joke. For 10 days, the British pound swung amazingly from weak to very weak to just weak again. Long-term government bonds, maturing in 50 years, gave up a third of their value in one stage, only recovering from this unprecedented decline when the Bank of England intervened. Foreign observers from the International Monetary Fund to rating agency Standard & Poor’s condemned Truss’ unfunded tax cuts, which led to the crash.
This is clearly a bad thing for Britain. The net approval rate for gear collapsed from minus 9 per cent to minus 37 per cent within a week. But Truss’ predicament also reflects a larger problem. Across the so-called advanced economies, the return of inflation has amplified the seriousness of exaggerated political gestures. However, most politicians did not understand the message.
For 23 years — the period from the collapse of the Long-Term Capital Management hedge fund in 1998 to Biden’s stimulus plan for 2021 — quiet inflation has enabled central banks to quell policy failures. Poor regulation may allow finance to become unruly; But in 1998 and then again and again, rapid rate cuts cushioned the shock. Politicians may shrug off preparing for a viral pandemic, but central banks have bought trillions of government bonds, providing politicians with cash to support stricken economies with stimulus checks.
The return of inflation changed all that. The primary task of central banks is to fix prices, so that the money in your pocket retains almost its value. Money is supposed to be a store of wealth and a unit of account: when it ceases to perform these functions, the operating system of the economy collapses. Because of the inevitability of fighting inflation, central banks now have to think twice before ensuring political expediency. The bailouts include lowering interest rates and buying government bonds. Inflation control requires the opposite.
Britain’s crisis illustrates the pain of this transformation. In announcing their program of unfunded tax cuts, Truss Treasury Secretary Kwasi Quarting acted like a startup spending money as if it were water, assuming that venture capitalists would endlessly provide cash. With interest rates at zero, capital seems to cost nothing. Investors will pour money into almost any project because of the TINA principle: There is no alternative.
Well, now there is an alternative. The Federal Reserve raised interest rates to combat inflation. Investors can stash their money in US mortgage bonds and get paid at 6.7 percent, more than double what they would have received just a year ago. Like a startup that burns money without generating revenue, a government that cuts taxes without putting pressure on spending can no longer count on the indulgence of markets. RIP TINA and Hi Mara. Markets are rational again.
But around the world, politicians still have to adapt. As The Economist recently noted, leaders responded to the energy crisis of the 1970s by asking people to wear an extra layer and reduce fuel consumption. “We will not starve,” the West German chancellor observed quietly. Today, by contrast, politicians are dumping subsidies on consumers and suspending gas taxes. When the 1973 oil shock hit, the true value of the British interest bill hardly changed. This time, the government is allocating 6.5% of GDP to protect citizens from fuel costs.
The response to the bailout extends beyond the energy sector and Europe. In the United States, the government guarantees bank deposits, mortgages, subsidizes health care, etc.; President Biden is now proposing to spend hundreds of billions of dollars to cancel student debt. By adding up the government’s contingent liabilities, The Economist estimates that Uncle Sam is in debt trouble worth more than six times GDP and that that percentage has recently risen. In 1979, the lowest quintile of earners in the United States received a means-tested benefit estimated at about one-third of pre-tax income. By 2018, it was about two-thirds.
Thanks to the 23-year inflation holiday, rich societies are accustomed to the idea that government can fix things. This is still true in important respects – the Bank of England backed government bonds last week, albeit on a limited time basis. But to maintain their ability to help in extraordinary times, politicians must exercise restraint in normal times. The inflation holiday is over. Adjustment will be painful.