Three Lessons for Americans from the British Pound’s Plunge

For now, the Bank of England has restored some calm to the global financial markets, which got the jitters a week ago, after the new British government of Prime Minister Liz Truss and her Conservative Party announced an enormous unfunded tax cut. As economists and financial analysts criticized this policy, calling it ill-timed and irresponsible, the value of the pound plunged, and so did the prices of British government bonds. In finance, though, the weight of money almost always wins out. So, when the Bank of England, which can create unlimited amounts of cash, announced on Wednesday that it would buy U.K. government bonds “on whatever scale is necessary” to “restore orderly market conditions,” investors snapped up assets that they had been treating like radioactive waste. In just a few hours of trading, the yields on thirty-year British government bonds, which move inversely with prices, went from 5.1 per cent to 3.9 per cent—an enormous rally. The pound also stabilized. After hitting an all-time low of $1.035 on Monday, it was trading at about $1.11 on Friday afternoon.

More to the point for Americans, the yields on U.S. Treasury bonds, which rose sharply during the sell-off in sterling, have also fallen since the Bank of England’s intervention. Since interest rates throughout the American economy are linked to the rates on Treasury bonds, that’s reassuring news for mortgage applicants, car buyers, and anybody else who is looking for a loan. As the Federal Reserve has increased the federal funds rate to fight inflation this year, mortgage rates and other borrowing costs have risen sharply. The last thing the economy needs is a further spike in interest rates unrelated to the Fed’s actions.

This goes to the first lesson of the past week’s events in the U.K.: the U.S. economy isn’t insulated from international events. To be sure, its sheer size—in the second quarter of this year, the gross domestic product was $25.25 trillion—and the fact that the United States is largely self-sufficient in energy gives us some protection against bad things happening overseas, such as the war in Ukraine. But today’s financial markets are so interconnected that shocks in other parts of the world can quickly spill over to Wall Street. Many of the biggest U.S. banks, including JPMorgan Chase, Citigroup, and Bank of America, have extensive operations in London. If the pound’s fall had turned into a panicked sell-off, accompanied by a wholesale collapse in the British bond market, who knows what losses these banks would have suffered?

Small wonder that U.S. officials have expressed concerns about the British tax cuts and their potential repercussions. According to Bloomberg News, some U.S. Treasury officials have been working through the International Monetary Fund, the international lender and watchdog based in Washington, to pressure Truss’s government to change course. Although the I.M.F. is nominally an independent agency, the United States is its biggest funder and exerts a good deal of influence over it. In a rare public rebuke of a G-7 country, the I.M.F. on Tuesday issued a statement in which it called on the British government to reverse course. (I contacted the Treasury Department and asked for a comment on the Bloomberg story, but none was forthcoming.)

The second lesson of the past week is that U.S. financial markets, and by extension the U.S. economy, are in a particularly vulnerable position because of the removal of an important backstop: the willingness of the Federal Reserve to ride to the rescue in response to a plunge in stock prices or bond prices, or some other alarming development. This safety mechanism was called into action during the 2008 financial crisis and again in early 2020, at the start of the coronavirus pandemic. On both occasions, the Fed slashed interest rates, and it also opened its monetary spigot to purchase financial assets that were otherwise struggling to find buyers—a policy known as quantitative easing. Right now, though, the Fed is pursuing the opposite policy: raising rates and selling off some of the Treasury bonds and mortgage bonds that it purchased earlier.

If a blowup did occur in the U.S. financial markets, the Federal Reserve could conceivably follow the Bank of England’s lead from this week and reverse itself, at least temporarily. But, having spent the past few months signalling to the markets just how determined it is to bring down inflation, the Fed would be loath to change course. Investors know this, and that is adding to the nervousness in the markets. Not surprisingly, Fed officials don’t appear to be huge fans of Trussonomics. Asked earlier this week whether the announcement of the British tax plan had raised the chances of a global recession, Raphael Bostic, the president of the Federal Reserve Bank of Atlanta, replied, “It doesn’t help.”

The other lesson of the pound’s troubles is that most Americans don’t realize how lucky they are to have the dollar as their currency. Not only is it accepted in many parts of the world as a means of payment and a store of value but its status as what economists call the international reserve currency also enables the United States to borrow heavily from overseas even as the country racks up more debt. When other countries introduce expansive fiscal policies that bear little relation to their future tax receipts, international investors tend to punish them by marking down their currencies—a lesson that Truss and Kwasi Kwarteng, the British Chancellor of the Exchequer, have just brutally learned. As the United States has piled up more than twenty trillion dollars in debt over the past twenty years, foreigners have shaken their heads but kept on accumulating dollar-denominated assets.

In early 2020, during the first stages of the pandemic, investors overseas—particularly in the Middle East and East Asia—sold Treasury bonds in large quantities, raising fears that the dollar’s special status might be coming under threat. Later in 2020, and particularly in 2021, foreign holdings of U.S. government debt rebounded strongly, but in the first half of this year they fell again. Unique factors have been cited for these developments, and, certainly, the recent strength of the U.S. dollar suggests that there is currently no lack of appetite for dollar-denominated assets. But the pound’s troubles should remind us that things can change.

During the nineteenth century and early twentieth century, sterling was the international reserve currency. Then the dollar replaced it. Luckily for Americans, no adequate replacement for the dollar has been found: the greenback still reigns. That situation could persist, but it won’t last for eternity. If it ever changes, look out.

Three Lessons for Americans from the British Pound’s Plunge
Source: Super Trending News PH