The Markets Made Me Do It!

British Prime Minister sacked the Chancellor of the Exchequer (head of Treasury) Kwasi Kwarteng on Friday, and economic commentary was predictable. Variations of “markets force government to backtrack!” were abundant, and echoed by Labour Party supporters (which would be surprising for anyone unfamiliar with British politics).

Of course, this is a variant of the “bond/currency vigilantes” stories that neoliberals love, and so features prominently in market discourse.

The reaction in the bond market should have been predictable by the Chancellor. In the current environment, looser fiscal policy is going to be met with higher policy rates. The trickier part of the situation was the fragility of the liquidity situation of U.K. pension funds — which the Treasury should have been aware of, since they have an entire team dedicated to meeting investors to gauge demand along the yield curve.

Returning to the MMT wrangling, since none of this should surprise anybody, it tells us nothing about MMT. However, I want to push back against the “financial markets constrained the government” narrative.

The MMT argument is that inflation constrains fiscal policy, and that is what happened. Under current institutional arrangements, the central bank reaction function is to hike rates as inflation rises (modulo the growth outlook). The Truss government should have been aware of the potential of such a reaction, and so this is just telling us what happens when amateurs run fiscal policy.

Saying that anything else is the constraint runs into problems.

• If default risk was allegedly the concern, just adapt procedures within the funding process to make involuntary default impossible (which might be the case in the U.K. in the first place). Since no serious observer argued that there was risk of default in this case, we cannot point to this in the first place.
• If rising bond yields is allegedly the problem, the central bank can just cap them. The reason why they do not that is because the central banks want to let bond yields float as part of how they use interest rate policy to control inflation. Although central banks could directly set bond yields, that is not being done in the U.K., and the conventional argument is that this would interfere with the central bank’s ability to control inflation. (I think the neoclassical arguments about interest rate pegging are silly, rather there are political issues with the central bank administering gains and losses in the bond market.)
• Furthermore, if rising bond yields are bad, why not just trigger a depression to keep bond yields nice and low?
• The “currency vigilante” story makes a bit more sense, but I think of currencies as just an extended notion of the “price level.” The correct attitude towards the currency is a benign neglect, such as the attitude of modern Canadian central bankers. If your domestic inflation situation is under control, the currency cannot fall too far without relative prices getting too far out of whack. Let the trend followers have their fun, but sooner or later, the currency value will revert.

The political discussions within the U.K. would likely be bewildering to a sensible outsider. Labour supporters are cheering on the destruction of the Conservative politicians. This fits British post-war history, where governments were periodically humbled by sterling crises. That said, it seems unusual for a left-leaning party to encourage worship of financial markets — what do they think will happen when they finally win an election? Luckily for me, that is not my problem.

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(c) Brian Romanchuk 2022