Where’s prudence gone?

While reading Simmon Hannah’s “A party with socialists in it”, I made a note to talk about Corbynism and Modern  Monetary Theory. I am writing an omnibus, review of that book, but think that a further note on MMT and its role in Corbynism, and the insights and weaknesses it brings to today’s crisis might be appropriate. In 2015, Corbyn flirted with MMT but by 2017, McDonnel, Meadway and Wren Lewis had won control of the Party’s economic agenda.

One of the things over the last few days or weeks is that we have just re-discovered the power of the bond markets and the extent to which they are driven by confidence, rather than current economic realities, although the realities are petty grim.

The Balance of Trade has been negative for decades but confidence in the UK economy’s ability to service the foreign debt is lower now we are out of the EU. The BoT is also worse now we are out of the EU and thus the pound is falling against the dollar [and the euro]. Sanjay Raja, chief UK economist of Deutsche Bank, testified at a Commons committee that these threats to the British economy are unique. Foreign holders of sterling have decided to sell which further impacts the FX rate; the fire-sale has led to a fall in UK Gilt prices which is a problem because the economy has been reconfigured. An additional factor is that the falling pound makes the gilt coupon payments less valuable to foreigners. Pensions are now primarily run by private sector organisations, there are index linked gilts and the pension funds are now permitted to use derivatives. This permitting of such high-risk investments by pension providers is another failing of the Bank of England on par with its failure to see the systemic weaknesses in the UK based globally significant banks and the building societies in 2008.

The sell-off of Gilts has been exacerbated by the Kwartung mini-budget which caused a further loss of confidence in the ability to service the debt, and fears of inflation.

Normally a declining FX rate is an asset to the Balance of Trade as our exports are cheaper, and imports more expensive. However, given the impact of Brexit and the current Future Trade and Co-operation agreement, the declining currency rate cannot rescue us; the decline in the FX rate means dearer imports, which given the amount of energy and food we must import, cannot be avoided, our obvious export market is now massively inhibited through the non-tariff import barriers; the only good news is that UK bond and sterling share prices should be internationally cheaper though.

There can be no macro-economic lab experiments, although some would argue that Chile in the ‘80s and Russia in the 90’s are examples of that. In both cases, tight money and privatisation led to the pauperisation of the populations of those states. The events in the UK today will be studied and argued about for years.

At its simplest, the pension funds have been borrowing money to increase their financial base to earn more for their members. Pension funds require long term plans, and the current rate of interest is an important factor in forecasting their long-term solvency. They have been using derivatives to manage/reduce their risk of adverse interest rate movements. These derivatives require the posting of collateral when the borrower, or the contractee is underwater. As bond prices fall, the collateral previously posted loses value and the funds need to sell assets to make good the shortfall. There is almost certainly a second route to a need to post collateral based on the increasing interest rates but I can’t see it and no-one is explaining it and this risk should be mitigated by buying index linked bonds.

This jeopardy for the pension funds leads the Bank of England to an unsolvable conundrum, do they increase interest rates to combat inflation, or do they buy up bonds to maintain the price of Gilts, which has the opposite effect.

One thing where the MMTers would seem to be wrong in that it is clearly not just foreign currency bonds that a government has to consider, domestic currency bonds, owned by foreigners also impact the economy through the exchange rate. If there’s an exodus from UK Gilts to the domestic currency of foreign purchasers, then this depresses the exchange rate; although maybe not, we need to see if the BOE restarts its bond buying programme. A final insight from MMT, they observe that currency depreciation should increase inflation but doesn’t seem to, let’s see if this time is different as the main items of inflation are energy and food, both of which are imported. A falling exchange rate increases the domestic value of FX debts and the MMT solution to this is to default on the debt. Who are the most important FX debt holders? They also say,

In extreme cases coma the worlds desire to accumulate claims against the deficit country could disappear entirely, in which case the country’s current account deficit would get forcibly squeezed down to zero. It might also happen relatively quickly. This is known as a ‘sudden stop’ and it usually associated with the sudden slow down or reversal of short term speculative capital flows, also known as ‘hot money’.

… Finally, it should be noted there are countries- such as extremely underdeveloped countries that could only access limited quantities of real resources relative to their population and are highly dependent on imports of food another life sustaining goods- where the well-being of their citizens cannot be solved within those nations own borders especially if their export potential limited regardless of the measures the country may employed protect itself from speculative capital flows.

Reclaiming the State – Mitchell & Fazi, Chapter 8

A lot of people, including me, but also the Bank of England and the Treasury need to have a think about what’s been happening and what effective policy solutions are.

This was edited on 15th Oct 2022.