European politics and economics were quite ‘exciting’ over the past days. The elections in Italy brought the expected outcome, with a former (?) neofascist ready to become Prime Minister; however, an overwhelming election victory it was not, with the right-wing alliance getting 44% and a large majority in both chambers of Parliament only because of a divided centre-left of Italian parties. Indications so far are that the new government will not do anything too crazy, but only time will tell. In any case I am less worried than I would if Marie Le Pen had won the French presidential elections, given that the Italian prime minister is much less powerful than the French president (at least with current constitutional arrangements). And Italy has strong institutions, among others in the form of a rather powerful president (more than his ceremonial role seems to suggest). But there is the risk that it will put the ECB in an uncomfortable position if spreads on Italian sovereign bonds get out of control again in reaction to crazy policies.
The UK in the meantime has shown how to best crash a currency. The economics behind it is very easy (indeed on the level of an A-level economics course or the MBA economics course I used to teach): Brexit (and the strong reduction in labour supply it has brought) has reduced potential GDP (long-term aggregate supply) and the economy seems currently to be at full capacity (judging from the unemployment rate and labour shortages). Fiscal expansion will push up aggregate demand beyond potential GDP and result in inflationary pressures. Pretending that tax reductions for the well-off will increase aggregate supply are simply illusionary. And even if the other policies suggested by the new government will increase aggregate supply, this can only happen in the medium- to long-term. However, I very much doubt that getting rid of environmental and labour regulations will help increase potential GDP; the easiest way to increase it would be to re-join the Single Market and the Customs Union and that is obviously not on the table. Rather, there is still the risk of a trade war with the EU if Liz Truss insists on the Northern Ireland Bill undermining the Northern Ireland Protocol and thus breaking an international treaty. Add to this a large current account deficit and the fact that the UK relies on the ‘kindness of foreigners’ to finance its current and now increasing level of government debt and it is clear why the British pound has depreciated heavily. As I said in my previous post politicians might be able to fool voters (and the right-wing media) but certainly they cannot fool the markets.
The Bank of England as independent monetary authority has stayed calm (in good English tradition?), but their statement on Monday evening suggests that it might be reluctant to raise interest rates too quickly in an attempt to off-set the pressure on the British pound that the fiscal expansion has caused. Another clear example that the independence of central banks has its limits in a country with no written constitution and where the previous government has trampled over long-standing norms and customs thus undermining the same institutions that are now so urgently needed. Either way, the bill for the reckless fiscal expansion will be paid by a large majority of the British population in the form of higher inflation (due to the depreciation and thus higher import prices) and/or higher interest rates translating into higher mortgage costs. What a way to run/ruin an economy!
Comparing the market reaction to the Italian elections and the UK mini-budget, the world seems upside down – muted reaction to a new right-wing government in Italy and strong reaction to the UK fiscal policy follies. I am old enough to remember when UK politicians and media declared in March 2020 that the impact of Covid-19 would never be as bad in the UK as in Italy, because the UK is so much better than Italy…. It was a deranged statement then and it seems even more deranged now, when looking back!
27. Sep, 2022