Why the market rejected the UK budget – and what it means for the changing nature of stimulus around the world

Consider the following statements about the relationship between markets and policymakers: “(They) are light years of mistrust and misunderstanding. But market reality has the final say. Wall Street votes by rising or falling stock and bond prices. Their reaction will ultimately make or break the president’s plan.”

Here are the words of Stewart Eisenstadt, advisor to President Jimmy Carter, This could be a warning to Prime Minister Liz Truss and Chancellor of the Exchequer Kwasi Kwarteng about the hard lessons he learned from his failed budget in early 1980 (which he had to withdraw). By announcing an over-budget with good intentions and good factors, they acted as if we were still in a pre-COVID era, where economic weakness and subdued inflation allowed unbridled tactical stimulus.

In fact, the tactical stimulus toolkit that politicians use in abundance is constantly changing, and now faces different constraints than the struggle President Carter faced. The market’s veto can easily offset the stimulus enacted by politicians, vetoing policy efforts to tighten financial conditions by raising interest rates, lowering the currency and lowering stock prices.

The market rout in the UK was an extraordinary rebuke from investors of a business-friendly but overextended fiscal plan, and it reminds us that the reality of stimulus is changing before our eyes. This constraint on stimulus capacity is neither limited to the UK nor to fiscal policy.

Hypothetical over-budgeting of the old rules

The UK economy is experiencing the worst of the US and Eurozone problems. Like the US, the country has a broad-based inflation problem, which has pushed the Bank of England’s interest rate path towards US levels (now higher), while inflation in the Eurozone is narrower, so there is less resistance to the ECB’s policy rate.Like the Eurozone, the UK is experiencing a severe energy shock that far exceeds the US energy headwinds

Having to navigate the worst of both sides of the Atlantic, the incoming administration will always address the cost of living crisis through fiscal policy. Indeed, the market didn’t get out of hand when Prime Minister Truss announced major fiscal measures to cap household energy bills at £2,500 over the next two years.

However, when Chancellor Kwarteng outlined his plans for massive tax cuts, markets took a nosedive – the 10-year gilt then surged nearly 100 basis points and the pound fell as much as 9%.

Markets see energy price caps as a political necessity, but parts of the new budget exceed expectations for profligacy and fiscal generosity, including the (highly regressive) removal of high-income tax brackets. A few years ago, markets might have ignored these tax cuts – but when inflation is around 10% and the economy’s potential is under pressure, they worry that policy will push up demand and threaten the inflation mechanism, pushing monetary policy even tighter.

Despite the size of the new budget, there is nothing wrong with the intent of this fiscal effort. First, to protect consumers to mitigate a looming recession, and second, to incentivize investment to drive mid- to long-term growth potential. A small package that focuses on essentials and no throwback giveaways might work. The wrong idea is a new reality that ignores stimulus constraints.

Two lessons from Carter’s budget

President Carter may have told Kwarteng that any plan must be acceptable to the market, despite the desire to be bold. If market makers exercise their veto power by selling gilts (thus pushing up market rates), sterling and UK equities, any positive stimulus to fiscal policy could be offset by the resulting tightening of financial conditions.

While low taxes may attract investment, unstable currency and financial volatility could scare them away. Not to mention the risk that the plan may not be politically viable. While Chancellor Kwaten said “no comment”, the first lesson of the limited stimulus capacity is that the market’s reaction to policy cannot be ignored.

The second lesson concerns the importance of structural anchoring of the inflation mechanism. Carter’s budget was less dramatic than the UK’s (indeed, the market fire was simply sparked by the government’s new estimates of the deficit), but the US inflation mechanism had been broken in 1980, and inflation expectations were not anchored. The government had to withdraw the budget and resubmit the cuts.

Kwarteng’s problem is quite the opposite: Britain still enjoys the luxury of anchored long-term inflation expectations, but it is his budget profligacy that calls into question the durability of such hard-earned expectations. The market is right to remain vigilant. Recall that the original energy price cap policy was not voted down, but in a world with structural inflation risks, there is a big difference between necessity and profligacy.

The future of stimulation machines is changing

March we quarrel in these pages Stimulus machine “splashes but doesn’t break”. Our main concern at the time was that with inflation high, the tactical use of monetary policy was limited and deprived a slowing economy and shaky markets of the rate cuts once taken for granted. However, systemic stimulus to support the economy in times of crisis is still possible.

What has changed? We see the UK rout as evidence that constraints on tactical stimulus have clearly expanded from monetary policy to include fiscal policy.President Biden has made it clear sad The Build Back Better Act, a massive spending bill that focuses on broad social programs and a green transition, cites concerns about inflation in his party.

However, we still believe that the structural stimulation capacity is still there. If the UK were to face existing systemic risks tomorrow, similar to the COVID-19 pandemic, the market would be unlikely to use its veto power.

Philipp Carlsson-Szlezak is a managing director and partner in BCG’s New York office and the firm’s global chief economist. Paul Swartz is a director and senior economist at the BCG Henderson Institute in New York.

The views expressed in Fortune.com review articles are those of their authors and do not necessarily reflect the views and beliefs of the authors wealth.

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