Death, taxes and national income identities: A frightening tale for the British pound
“The only two certainties in life are death and taxes,” says the adage.
It may very well be true, but economists like to add a third certainty to this list: national income identities. Perhaps the most famous of these identities is the one stating that a country’s net national savings – basically its ability to self-fund its investments – is always equal to its current account — that is, the balance of its trade and net foreign income. This identity never lies, and these days it is telling a simple yet frightening tale for the United Kingdom and the British pound — all without having to invoke catastrophic or prejudiced punditry.
Here is the identity’s tale. The UK typically spends a significant portion of its income on investments, but its residents do not save enough to pay for it, even after the recent, deadly pandemic-driven savings glut. The British government does not help, for its own savings (tax revenues minus expenditures) have been negative for at least a decade.
Of course, someone has to pay for those private investments and fiscal expenditures. Enter foreign investors, who have so far been buying plenty of British stocks, bonds and other assets — instead of British goods and services. The result? Large current account deficits.
Economists label this treacherous combination “twin deficits” and would normally expect the domestic currency, in this case the pound, to depreciate in turn, both to continue to make British assets attractive and to help reduce the UK’s trade deficit. However, Brexit has made this task more challenging for the pound. Thus, no one should be surprised by its continued weakness.
Twin deficits are common in emerging economies and contribute to making foreign investors there jittery — especially since those economies tend to borrow in reserve currencies, like the U.S. dollar. Therefore, whenever their governments dare to undertake unorthodox (and most often doomed) economic policies, foreign investors quickly rush to the door, turning an orderly devaluation into a precipitous fall.
These days, faced with those facts and a collapsing pound, many commentators have quickly concluded that markets are giving the UK the “emerging market” treatment, implying that otherwise basic economic truisms should not apply to Great Britain. Once again, national income identities help clarify matters.
To begin with, foreign investors have increasingly attractive alternatives for their money, first and foremost the safety of U.S. Treasury securities, whose yields have now reached high levels thanks to the Federal Reserve’s early determination to fight inflation with interest rate hikes.
Add to this the fiscally reckless “mini budget” proposed by the newly appointed Prime Minister Liz Truss based on the largely discredited notion that tax cuts both stimulate the economy and facilitate fiscal rectitude.
In short, as the need to attract foreign capital in the UK grows, its appetite for British assets diminishes, pushing down the pound even further without having to invoke the diminishing importance of Great Britain in world affairs, the decline of a formerly mighty empire or even the recently lousy performances of the Three Lions of England in soccer.
Can the downward trend for the pound be reversed? If the Bank of England were given free rein, as one would expect of an independent central bank in normal times, it would raise rates at the Federal Reserve’s pace to both control domestic inflation and attract capital in search of less stormy waters. Both would stabilize the pound, as they have contributed to strengthen the dollar despite the United States’s own twin deficits.
But these are not normal times. The “mini budget” implied an expansive fiscal policy in direct conflict with those goals. It has also made foreign investors jittery enough to induce a sell-off of UK gilts, pushing market interest rates to levels likely to hurt the British government’s ability to fund its fiscal deficits as well as the ability of many Britons to pay their mortgages and of British pension funds to manage their liabilities.
All the while, Truss and her chancellor of the Exchequer, Kwasi Kwarteng, did not seem inclined to compromise, despite abysmal poll numbers and a restless Parliament. The result? The Bank of England had to resort to buying gilts to lower long-term interest rates, in a fashion evoking the “whatever it takes” of Mario Draghi’s European Central Bank during the euro’s crisis but also further depressing the pound by putting more of it in circulation.
Eventually, Truss and Kwarteng reverted their position and abandoned their proposed tax cuts with “humility and contrition” after facing internal Tory revolt. But the damage has been done, and the greater political risk they stoked will further fuel foreign investors’ reluctance to invest in the UK.
National income identities have spoken: The UK’s twin deficits are unlikely temporary and so is the pound’s weakness. Investors and pundits beware.
Paolo Pasquariello is a professor of finance at the Ross School of Business, University of Michigan, with longstanding research and teaching interests and past professional experience in international finance and financial market quality issues.