The domestic economy vs the global economy
Which should have priority?
There is heated debate in Britain about the Bank of England’s decision to raise interests rates in the face of inflation and a cost-of-living crisis. This at a time when energy and food prices are fixed by the ‘invisible hands’ of traders and speculators in global markets. (Forthcoming post alert: how oil prices are set will be published soon).
In the context of falling incomes, higher interest rates make household and corporate debt more expensive and perhaps unpayable. (By contrast, inflation erodes the value of debt). Higher rates also tend to inhibit domestic investors who need the certainty of much higher rates of return if borrowing for investment is to be profitable.
Despite these effects, interest rates are increased by the public authorities (on the advice of mainstream economists like Larry Summers) to tackle the inflation of prices and wages. In the current weak economic context, they do so by destroying demand. In other words, their purpose is to slash economic activity in order, it is argued, to bring down domestic prices and wages because higher rates tend to lower levels of investment and increase unemployment.
Falls in investment and employment lead to falls in income, tax revenues and profits. That much is predictable. What is questionable is whether higher rates can deal with the inflation caused by prices in global markets - prices that are beyond the reach of the Bank of England. The good news is that higher rates do make sterling more attractive to foreign investors: their inward flows of capital strengthen the currency, which lowers import prices (and therefore inflation). The bad news is that exports become more expensive and less attractive to foreign buyers.
Today a member of the House of Lords, ex- Permanent Secretary at the UK Treasury, a Visiting Professor at King’s College London, and a man that once admitted to a “monumental collective intellectual error” in failing to see the Global Financial Crisis coming…commented in the Financial Times on the weakness of the British currency .
Lord/Professor Nicholas Macpherson believes the reason for sterling’s weakness is straightforward: the Bank of England is not offering foreign investors the lure of a “premium” (i.e. interest rates higher than US rates) to buy (spend their dollars on) British debt or bonds. So foreign investors are instead turning to the dollar, where the Federal Reserve has applied a higher ‘premium’ on US bonds - making investment in, and returns on those bonds more profitable.
Lord Macpherson is keen to embark on a currency war. He is desperate for sterling to compete with the dollar to lure back foreign capital. He explains why:
We ..need foreign investors to buy our public debt. As former BoE governor Mark Carney memorably put it, we rely on the kindness of strangers. But however kind those strangers are, they require a premium to buy bonds in a depreciating currency. You don’t have to agree with the Bank of America’s claim that sterling has become an emerging market currency to recognise they may be on to something.
Professor Michael Pettis, co-author of Trade Wars are Class Wars, contradicts Lord Macpherson with this tweet:
In other words, to satisfy the needs (or greed) of global and mobile capital, Britain must build up imbalances in the domestic economy.
In the 1970s, as readers know, the British government ‘liberalised’ the nation’s capital account. In other words the government stopped managing inward and outward flows of capital and removed all barriers to that movement. Under the Bretton Woods system, the purpose of such management had been to maintain full employment at home and achieve domestic macroeconomic objectives, while stabilising the balance of payments and the currency.
The domestic economy was then run largely in the interests of what can crudely be defined as the 99% - domestic citizens and voters. Above all, the government wanted to manage capital flows in order to retain the power to maintain full employment and to tax domestic financial activities, income and wealth. Governments needed those tax revenues to help balance the public finances.
All that changed in the mid-1970s. The British economy, in concert with other western economies, was re-oriented towards the interests of foreign investors in global markets. These can crudely be defined as the 1%. One of the many deleterious consequences of that transformation is that it is now harder for governments to tax profits made by companies like Amazon, Facebook and Google. Thanks to the absence of any barriers to flows of capital, they simply export their profits to tax havens. This loss of tax revenues has made it harder to “balance the nation’s books” - and goes some way to explaining the UK government’s public deficit.
But I deviate. Professor Pettis commented further on Lord Macpherson’s article and reminded us that Britain is attractive to foreign investors precisely because the capital account is not managed. Instead, even while it is given credibility by taxpayer-financed public institutions that maintain legal protection for foreigners, it is “totally open”. Foreign investors can shift capital in and out at a whim, confident that the British taxpayer will sustain the legal system that honours their contracts.
He concludes his interesting thread with this:
The question we as citizens and voters must address is this: why do our academics and regulators deploy the nation’s collective resources to maintain and support domestic imbalances and a “global regime” that provides capital gains for the 1% and losses for the 99%?
Transformation of that regime is the theme of this substack, and will be discussed in future posts.
Thank you as ever