From The Economist Buttonwood Writer
I am absolutely determined to make sure we deal with our problems, to make sure that Britain stays the course, to make sure that it doesn't take from this credit rating the wrong message which is we should go and borrow a lot more. I'm absolutely clear we're not going to do that.The dangers ahead are of not one, but two, vicious circles. The first is the one seen in Europe, where austerity programmes designed to reduce debt to GDP ratios, end up sending the economy into recession. The debt-to-GDP ratio then rises because GDP falls faster than debt. The government will be urged to cut taxes, or to spend more money on infrastructure. Even if the government follows this advice, it seems doubtful if it will do enough - perhaps a couple of billion - to shift the economy.
The second vicious circle relates to the relaxed attitude of the authorities to the decline of the pound. Perhaps British memories are unduly affected by the aftermath of September 1992, when the pound's exit from the Exchange Rate Mechanism appeared to liberate British economy policy. The government was able to cut interest rates substantially, and the pound's fall did not result in imported inflation; two years after the exit, inflation was just 2.2%
As Andrew Sentance, a former monetary policy committee member, points out in today's Sunday Times, the UK's historical experience with devaluation has not always been so benign. The pound's first post-war devaluation came in September 1949, a 30% drop against the dollar. Two years later, inflation was 12.3%. However, the Korean war may have been more responsible for pushing up prices. Harold Wilson's "pound in your pocket" devaluation in November 1967; two years later, inflation was 5.4%, having hit 6.3% earlier that year.
Of course, there was another big depreciation in the wake of the financial crisis. That did not result in massive inflation, although Britain's rate has been steadily above the 2% target. As Mr Sentance notes
We have acquiesced to a relatively high inflation rate driven by a weak pound which, in turn, squeezes consumer spending.Nor did the depreciation do a lot for Britain's trade position, as we noted recently. This time round, we are already seeing a surge in petrol prices, which are 138.3p a litre (or about $9.40 a gallon to give some context for American readers).
So this vicious circle might run as follows. The Bank of England is relaxed about lending the pound fall, and foreign investors are reluctant to hold low-yielding gilts.* Inflation rises further, making domestic investors similarly reluctant. The Bank steps in to buy gilts and hold yields down, but this evidence of further monetary easing is bearish for sterling, causing the whole cycle to turn again.
Perhaps the problem is expecting so much of monetary policy. As Mr Sentance notes
We need to recognise that growth will be disappointing in relation to past trends and that structural adjustments are needed in the UK and other western economies. Expecting central banks to sort out these problems is looking in the wrong direction.* Because the UK runs a current account deficit, foreign investors have to own up buying some UK assets, although not necessarily gilts. But that says nothing about the price at which they will hold the assets. They may demand higher yields for the risk of owning sterling assets, adding to the funding problems.