Trying to ignore and outsmart macroeconomic fundamentals can be costly, as Britain’s new government has just learned.
This British experience also has important policy lessons for sound macroeconomic management in Bangladesh as it attempts to combat rising inflation and balance of payments pressures.
A new British Conservative government led by Liz Truss came to power on September 6, 2022, just two days before Queen Elizabeth died.
Prime Minister Liz Truss and her new Chancellor of the Exchequer (Finance Minister) Kwasi Kwarteng announced an ambitious growth-oriented macroeconomic agenda that proposed lower personal and corporate income taxes, lower stamp on properties and offer tax incentives to new investments.
The measures come on top of an earlier decision to cap annual household energy bills at £2,500.
The tax cut scheme would cost the Treasury £45bn while the energy cap would cost £60bn in 6 months.
This massive cost of the tax cut and the ceiling on household energy expenditure would be financed by the budget deficit.
The policy was announced on September 23.
The following Monday, when the markets opened, there were serious adverse reactions.
The pound, which was already in deep trouble, went into freefall, interest rates on long-term government bonds jumped in anticipation of more Treasury borrowing and share prices plunged.
Overall, the market’s perception of a financial crisis has increased and confidence in the management of UK macroeconomic policy has taken a nosedive.
What went wrong?
The UK economy has already been under severe pressure due to the adverse effects of Brexit (leaving the EU), Covid-19 and ongoing global inflation.
Britain’s inflation rate had hit 9% before the announcement of the mini budget and the currency had depreciated to a low of $/£1.12.
The market was expecting policies to control inflation and support currencies.
Given that UK reserve levels are low, currency-based interventions to support the pound sterling are not a feasible option.
The only options are to tighten monetary and fiscal policies in order to depress demand.
While the Bank of England is independent of government and has intervened to raise interest rates, the Treasury has given the opposite signal by seeking to cut taxes and stimulate the economy.
The market perceived that fiscal policy was undermining monetary policy and there was a loss of confidence in the macroeconomic outlook which triggered the depreciation of the UK currency, falling government bond prices and falling stock markets. .
The new government should have consulted the Bank of England, independent researchers and the private sector to discuss its plans.
He should also have understood that the British economy was facing enormous inflationary pressures and that the top priority was to reduce inflation through a coordinated set of monetary and fiscal policies.
Instead, he ignored market fundamentals and prioritized delivering on his campaign promises to cut taxes and spur economic growth.
There is nothing inherently wrong with the government’s idea of cutting taxes to stimulate growth, but the timing was wrong.
When the economy is facing strong inflationary pressures, the top priority is to reduce inflation and stabilize the currency by raising interest rates.
The Bank of England has focused on that.
The Treasury should have supported this policy position and made other complementary reforms to reduce wasteful spending, support programs that help the low-income group, and deregulate the economy to reduce bureaucracy and inefficiencies.
The growth-oriented fiscal policy could have waited another 6-9 months to allow time to restore macroeconomic stability.
The political fallout from this poor macroeconomic policy-making was considerable, with pressure on the new Prime Minister to resign.
The government backtracked and reversed many of the tax cuts proposed in its mini budget.
To calm the markets, Liz Truss also sacked her finance minister.
These measures drew positive reactions as the downward spiral of the British currency reversed itself, prices of government bonds stabilized and the turmoil in the stock markets subsided.
However, the markets remain nervous and great uncertainties reign.
Although Bangladesh’s economy is fundamentally different from the British economy, there are important lessons to be learned from this botched British experience in macroeconomic management.
Bangladesh’s economy also faces difficult macroeconomic stability challenges.
The current account deficit has soared, some 25% of foreign exchange reserves have been depleted since August 2021, short-term debt has increased and inflation has accelerated.
The government responded by partially depreciating the currency, imposing import controls, raising tariffs, and increasing budget subsidies on fertilizers and energy products.
Import controls have reduced the current account deficit, but there is continued pressure on the balance of payments, a shortage of foreign currency and inflationary pressure is on the rise.
The large loss of reserves and the prevalence of multiple exchange rates have increased the short-term vulnerability of the foreign exchange market.
Lessons for Bangladesh
As in the case of the UK mini-budget, Bangladesh’s policymaking is heavily focused on supporting the economy to accelerate GDP growth.
This is reflected in the management of monetary and fiscal policies.
The government is trying to promote economic growth by capping the lending rate at 9%.
The tax effort has either decreased or stagnated. The budget deficit has increased.
These growth-oriented policies come into serious conflict with the need to stabilize the macroeconomy through policies to reduce aggregate demand.
Low and now negative real lending rates have increased demand for private credit from 8-9% a year ago to 14% now, adding to inflationary and balance of payments pressures.
The expansionary fiscal policy also stimulated demand rather than reducing it.
Learning from the botched UK experience, policy needs to refocus on demand reduction through a judicious mix of exchange rate, interest rate, tax and spending policies.
The massive loss of reserves reflects an unsustainable effort to prevent further depreciation of the Bangladeshi taka, which remains overvalued despite the recent depreciation due to past exchange rate mismanagement which saw a real appreciation of the Bangladeshi taka of 71% between fiscal year 2011 and fiscal year 2020.
The government got off to a good start by announcing its intention to let the exchange rate be determined by the market.
But it quickly changed course and instead adopted a multiple exchange rate (one for exports, one for remittances and one for imports) with fixed rates for each of the transactions.
The government has now reached a situation where a further loss of reserves would jeopardize the management of its foreign transactions, including short-term debt.
The best solution would be to eliminate multiple exchange rates and leave a uniform market-determined exchange rate.
Exchange rate flexibility should be combined with policies to reduce demand pressure in foreign exchange and domestic markets.
The most fundamental reform is the need to remove the lending rate cap.
It is ridiculous to maintain a negative lending rate when inflation is on the rise and the exchange rate is under pressure.
Credit growth must be slowed, not increased, to lower inflation and reduce import demand.
Monetary policy should be used to monitor and adjust interest rate movement if necessary.
Fiscal policy should also be used at present to reduce demand.
The tax effort must be reinforced by a well-considered and productive tax reform.
Many of the elements of the required tax reform are well known.
Strong political will at the top is needed to implement the required tax reforms.
Expenditure management should focus on reducing subsidies and increasing social sector spending in health, education, water supply and social protection.
The priority given to infrastructure spending should continue, but efforts should be redoubled to increase the effectiveness of this spending by carrying out projects on time. The budget deficit should be reduced to 5% of GDP or less.
The growth focus of monetary and fiscal policies can be restored once the macroeconomy stabilizes.
The author is vice president of the Policy Research Institute of Bangladesh. He can be reached at [email protected]