It’s a momentous week, not just because the UK has said a final farewell to its longest-ever serving monarch. Tomorrow (Thursday) the Bank of England (BoE) is expected to announce what one newspaper calls “the biggest rise in borrowing costs for at least 25 years” in an effort to reduce inflation from its current 8.6%. Next day, the Chancellor of the Exchequer, Kwasi Kwarteng, is expected to give details of the new Conservative administration’s relaxed attitude toward government spending of money it will need to borrow. This borrowing could be as much as £200 billion ($230 billion), rivalling the more than £300 billion that government handed out during the Covid-19 pandemic.
This will push up the already high UK budget deficit; gross UK government debt is more than £2.3 trillion, very close to 100% of gross domestic product (GDP). Hopes of closing the deficit look slim, as the new Prime Minister, Liz Truss, has in her campaign to win the leadership of the governing Conservative Party pledged there will be “no new taxes”; indeed she also promised around £30 billion of tax cuts. Increasing spending and cutting revenues is a gamble “on a huge scale” which one leading commentator calls “frightening”.
On the other side of the Atlantic the Federal Reserve is widely expected today (Wednesday) to announce a third successive 0.75% interest rate increase, or perhaps even a full percentage point. Previous rate rises this year have done little to calm US inflation, which in August was an annualized 8.3%, against 8.5% the previous month. So-called ‘core’ inflation (inflation minus the contributions of food and energy costs, which are regarded as volatile) rose by 0.6% over the previous month.
US energy bills: source employamerica
Tighter monetary policy – pushing up interest rates, making borrowing more expensive – is the orthodox economic policy in the face of high inflation. Central bankers and governments however worry that too much ‘tightening’ could shift the balance too much in the opposite direction – and create conditions for a recession. The World Bank is only one institution to be alarmed about this.
From getting inflationary signals wrong in 2020 and 2021 (it wasn’t ‘transitory’ after all), central bankers may again be taking a wrong turning according to the World Bank and people such as Maurice Obstfeld, former chief economist at the International Monetary Fund (IMF). “Just as central banks, especially those of the richer countries, misread the factors driving inflation when it was rising in 2021, they may also be underestimating the speed with which inflation could fall as their economies slow”, he has said.
Central bankers, playing ‘catch-up’, may get out of the frying pan and jump straight into a fire.
Cheap money and zombies
In the UK, the government has signalled its readiness to borrow inordinate amounts to fend off supposedly unacceptable energy costs. Britain has had some 15 years of ultra-low interest rates and almost £1 trillion of quantitative easing since the Great Financial Crash of 2008. This ‘easy money’ has done very little for economic growth, which the Truss government says it will boost to 2.5%/year; it will be miraculous if that’s achieved given that annual average growth rates have roughly halved since the 1960s and productivity has hardly increased at all since 2008.
To be sure, low interest rates have helped many ‘zombie’ firms to survive. Zombie firms are businesses unable to cover their debt servicing costs from current profits. But although that has prevented many from becoming unemployed, it’s unhealthy for the economy as a whole, suggests the Bank for International Settlements (BiS). It says that “zombies weigh on economic performance because they are less productive and because their presence lowers investment in and employment at more productive firms” and that the numbers of zombies globally has grown “since the late 1980s”. In the US, as many as 20% of the largest 3,000 public companies are zombies, with debts of some $900 billion (£791 billion) according to one estimate; the figure is even higher in the European Union (EU).
As rates have started to move higher, firms exposed to unsustainable debt levels have started to feel the squeeze; in August, there were 35,355 bankruptcy filings in the US, 10% higher year-on-year according to the American Bankruptcy Institute (ABI). Amy Quackenboss, the ABI’s boss, says that debt problems are not just for firms but also financially “distressed households” who are “experiencing expanding debt loads amid rising interest rates, inflation and supply chain concerns”. 56% of Americans now say that price increases are causing financial hardship for their household according to a Gallup poll.
In the UK, household debt peaked in early 2008 at more than 150% of disposable income and in early 2022 was above 131%. According to one estimate average personal debt in the UK “equates to around 107% of average earnings per adult”.
The levels of personal and national debt in the UK and the US will rise in the coming years. Rising and possibly unsustainable debt is becoming a social concern on both sides of the Atlantic. Total consumer debt in the US rose by $23.8 billion in July to a record $4.64 trillion, according to the Federal Reserve. The US national debt is almost $31 trillion (above £27 trillion) and rising fast.
At what point does this indebtedness become unsustainable? Might a ‘debt jubilee'(a round of forgiveness of debts) be proposed by governments? There’s already been an example of this in the US, where President Joe Biden has announced plans to forgive up to $20,000 in student loans for individuals earning less than $125,000. Credit card debt in the US is getting out of hand; inflation is exceeding wage gains so more households have relied on revolving debt. Consumers in their 20s and 30s and those in the lowest income brackets are more likely to carry a balance to cover daily expenses such as groceries, child care or utilities than older generations. According to one survey, 60% of credit-card debtors are now carrying debt for a year or more. Loading up the credit card will become more expensive as rates rise.
Central bankers pride themselves as being guardians of price stability but the only tool they have to combat inflation higher than they desire is putting interest rates up, to try to take the steam out of an economy. The Federal Reserve and the BoE ‘target’ inflation at an annual 2% – meaning they want inflation of 2% a year. 2% doesn’t sound much but after five years of 2% inflation the loss of purchasing power of fiat money is 9%; after 10 years that loss is 18%. If the current high inflation rate sticks around for a decade then the loss of purchasing power of the Dollar or Pound Sterling will be close to 60%.
Yet while this pushing up interest rates may work in the US, where inflation is largely a factor of a rapid (Covid-19-induced) contraction followed by a swift expansion, it may be less successful in the UK or EU, where on top of the exit from Covid-19 consumers face high energy prices as a result of the Russo-Ukraine war. Being more self-reliant in energy the US is less subject to international energy price rises.
Central bankers face a difficult dilemma. If they push up interest rates only mildly this will fail to stifle inflation. If they move aggressively that could kick off a recession, stock market collapses, and a shrinking economy. They are also facing (as always) a changing macro-economic environment, in which food prices, which have been rising fast due to a variety of factors (including record fertilizer prices) appear to be cooling: the UN’s Food and Agriculture Organization’s price index, which tracks the most globally traded food commodities, fell in August for the fifth successive month, although was still almost 8% higher year-on-year.
A year ago, this newsletter said a major worry was the possibility that the world might drift into stagflation – a combination of a stagnating economy and high price rises. So far this year around 90 central banks have raised their interest rates, and about half by at least 0.75%, the broadest tightening of monetary policy for 15 years. 2008 ushered in an era of cheap money, cheap credit; 2022 will be remembered for laying the ground for global stagflation. The irony is that as US interest rates rise, the Dollar strengthens, other currencies weakens, and thus imported inflation increases for those countries whose currencies have slid against the Dollar. It begins to feel like a vicious spiral, in which everyone needs to put up interest rates as a defensive measure – and debt interest payments go up for all.
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