The US Treasury Secretary Larry Summers issued a grim warning after the British pound touched an all-time low this week: "The U.K. has lost credibility and risked triggering a global crisis with an utterly irresponsible tax plan," he said.
Summers is a Harvard University professor who served under Presidents Bill Clinton and Barack Obama. In a tweet he said the U.K. government's sweeping tax cuts hurt the credibility of the government as an economic superpower at a time when the world is already confronting painfully high inflation.
Summers said that he was very pessimistic about the consequences of utterly irresponsible UK policy on Friday. I didn't expect markets to get so bad so quickly. A strong tendency for long rates to go up as the currency goes down is a hallmark of situations where credibility has been lost. The pound fell below $1.09 for the first time since 1985, dropping as low as $1.03 as investors weighed Finance Minister Kwasi Kwarteng's so-called mini-budget that included large tax cuts for individuals and businesses. The currency has rebounded a bit since, hovering around $1.07 as of Tuesday afternoon.
Summers said the pound's reaction is more typical of a developing nation, not an advanced economy like Britain, the sixth-largest economy in the world.
British credit default swaps still suggest negligible default probabilities, but they have risen very sharply, he said. I can't remember a G 10 country with so much debt sustainability risk in its own currency. Credit default swaps are financial agreements designed to protect investors against default.
The plan from the prime minister Liz Truss administration last week included 45 billion pounds $49 billion in tax cuts, which comes at the same time the British government is spending more than 60 billion pounds to subsidize gas and electricity bills for households amid a worsening energy crisis.
The sudden sell-off of the pound and British bond markets comes as investors brace for more aggressive interest rate hikes from the Bank of England. The central bank's chief economist Huw Pill said on Tuesday that the tax cut and spending plan will be met with significant action from policymakers.
Pill said on Tuesday at a conference hosted by Barclays and the Center for Economic Policy Research in London that we have seen the recent significant news in the past few days. That has had significant market consequences as well as significant implications for the macro outlook. It is hard not to draw the conclusion that all this will require a significant monetary policy response. The Bank of England's monetary policy committee voted to increase the Bank Rate by 0.5 percentage points to 2.25% last week. The group meets in November. The financial markets are expecting that rates could rise to 6% next year.
Summers said that he would not be surprised if short-term rates tripled from current levels to above 7% over the next two years, given the growing economic concerns. He suggested that the pound could drop and fall below parity with the euro and the U.S. dollar. He said that such an event could trigger a chain reaction around the world.
He said that the pound will find its way below parity with the dollar and euro. A currency crisis in a reserve currency could have global consequences. I am surprised that we have heard nothing from the International Monetary Fund.