The British pound hit a record low against the dollar on Monday after UK Prime Minister Liz Truss, a fan of "trickle-down economics," announced a sweeping spending and tax cut plan to rescue the British economy from recession on Friday.
What's happening: Investors were taken aback by the new government's choice to institute its largest tax cut in 50 years while boosting government spending and borrowing with inflation near 40-year highs. Citibank analysts called the decision a "huge, unfunded gamble for the UK economy." Markets dropped precipitously on the news.
But Truss took a cue from former US President Ronald Reagan as she defended her actions. The government is "incentivizing businesses to invest, and we're also helping ordinary people with their taxes," she told CNN's Jake Tapper last week, referencing Reagan's trickle-down ideals.
So is she right? Let's dust off our history books and see.
Interesting parallels: When Reagan arrived in Washington in 1981, inflation rates were nearly 10% and tight monetary policy had taken interest rates to over 19%. But much like Truss, Reagan argued that massive tax cuts and deregulation would stimulate productivity and he championed a sweeping tax cut that was passed by Congress that year.
Truss' government points to that as proof that lowering taxes doesn't necessarily drive up prices. Inflation fell and growth surged under Reagan, it says.
But the policy came at a price. According to US Treasury estimates, Reagan's tax cuts reduced federal revenues by about 9% in the first couple of years. Meanwhile, unemployment kept rising.
Congress concluded the sweeping tax cuts were unsustainable. With Reagan's approval, it raised taxes by a lot in 1982, 1983, 1984 and 1987.
A lesson from history: "When tax cuts are really too big to be sustainable, they're often followed by tax increases," wrote David Wessel, director of The Hutchins Center on Fiscal and Monetary Policy.
And in the near term, for the United Kingdom, there's also a huge risk to its currency. The US dollar appreciated during the Reagan tax cuts because it benefits from global reserve currency status. A strong currency helps contain inflation and makes imports cheaper. Britain, seeing record drops in its own currency, doesn't have that advantage.
The bottom line: The British pound will likely hit bottom in three months, wrote Goldman Sachs economist Kamakshya Trivedi in a note Monday. "But if [tax] policy does not eventually change tack, then we would expect Sterling underperformance to persist for longer," he said.
That's bad news for markets around the globe. S&P 500 companies that have a global footprint are getting hit hard by the strong dollar and weakening pound — about 30% of all S&P 500 companies' revenue is earned in markets outside the United States.
The last time taxes in Britain were cut this much, there was rampant inflation, a massive jump in debt and eventually an IMF bailout. "It's difficult to see how the pound can recover from here," wrote Fiona Cincotta, senior financial markets analyst, at City Index, in a note. "Investors are rapidly pulling out of UK assets, and who can blame them?"
Comments
Post a Comment