The British Pound Plunges Dramatically. The trigger is a plan with which the new finance minister, Kwarteng, actually wants to boost the economy. But investors fear it will do the opposite.
The new prime minister, Liz Truss, and her finance minister, Kwasi Kwarteng, shocked the financial markets with their budget proposal and caused the pound sterling to fall to an all-time low. Last Friday, the pound fell by around three percent to its lowest level in 37 years in response to Kwarteng’s billion-euro new borrowing plan. In the early morning, the British currency fell again at times by five percent and set a new negative record with a rate of 1.03 dollars. Recently, the pound recouped some of the losses. At the same time, UK government bond yields shot up. That means investors will charge higher interest rates when lending money to the UK government.
Like other European currencies such as the euro or the Swedish krona, the pound sterling has been under pressure for months, primarily because of the steadily gloomier economic prospects on the continent as a result of the energy crisis. However, the pound clearly stands out with its recent plunge. Such price movements of several percentage points within a few hours are highly unusual for currencies of large industrialized countries such as Great Britain.
Finance Minister Kwarteng triggered the price slide with a surprise at the presentation of the government budget on Friday. In addition to plans, already known from Truss’ election campaign, to save British consumers more than £60 billion in energy costs while cutting various taxes and levies without reciprocal funding, the minister announced that he would completely abolish the current top rate of income tax . People with more than £150,000 in taxable income will then only pay 40% income tax instead of the previous 45%, which is the same rate as those earning more than £50,000.
With this proposal, Kwarteng triggered a debate about justice because he wants to relieve the richest Britons by far the most in the current energy and inflation crisis. The market-radical concept behind it: The reduced tax burden frees money for investment and consumption, which should boost economic growth and create more prosperity for everyone.
On the other hand, the plan obviously makes investors and currency traders doubt the creditworthiness of the British government. The vague hope that economic growth will pick up is not enough for them to finance the fact that new borrowing is likely to increase by hundreds of billions over the next five years. Within minutes of Kwarteng’s budget speech in the House of Commons, UK bond yields jumped as the pound plummeted. The minister “shook investor confidence”, commented the “Financial Times”. In many media there was talk of an unprecedented market-liberal “experiment” that the government, which had been in office for only a few weeks, wanted to carry out.
The violent market reaction shows that the calculation, which most economists doubt anyway, that tax cuts are self-financing through stronger economic growth cannot be correct. On the contrary: the increase in bond yields makes the planned new debt considerably more expensive. The dramatic devaluation of the pound makes imports even more expensive, including energy, which many are already unable to afford, fueling inflation. This, in turn, should call the central bank into action. Additional rate hikes to those already announced are considered certain if the government implements Kwarteng’s budget proposal. On the financial market, participants are now expecting interest rates of more than six percent in Great Britain in the coming year.
Overall, the tax cuts could do the exact opposite of the economic boost promised by Kwarteng and Truss. Instead, interest rates are likely to rise, and with them the cost of borrowing for businesses and consumers, fueling inflation and ultimately slowing down economic growth.
