For several days of Britain’s financial meltdown, Prime Minister Liz Truss offered no comment. The Independent newspaper led Thursday with her picture under a snarky headline: “MISSING: HAVE YOU SEEN THIS PM?” Then Truss did comment, choosing local radio stations as an unthreatening venue. Her responses were so wooden the deputy leader of the rival Labour Party declared that “Truss has finally broken her long painful silence with a series of short painful silences”.
Acerbic zingers aside, Truss’s performance is no joke. For 10 days, the British pound has swung dizzyingly from weak to extremely weak to merely weak again. Long-term government bonds, maturing in 50 years, shed one-third of their value at one stage, recovering from that unprecedented plunge only when the Bank of England stepped in. Foreign watchdogs from the International Monetary Fund to the rating agency Standard & Poor’s have condemned Truss’s unfunded tax cuts, which triggered the rout.
Clearly this is bad for Britain. Truss’s net approval rating has collapsed from negative 9 percent to negative 37 percent in the space of a week. But Truss’s predicament also reflects a larger issue. Across the supposedly advanced economies, the return of inflation has magnified the riskiness of extravagant political gestures. For the most part, however, politicians have not gotten the message.
For 23 years — the period from the 1998 collapse of the hedge fund Long-Term Capital Management to the Biden stimulus of 2021 — quiescent inflation empowered central banks to muffle political failures. Weak regulation might allow finance to run wild; but in 1998 and repeatedly thereafter, swift cuts to interest rates cushioned the shock. Politicians might neglect to prepare for a viral pandemic, but central banks bought government bonds by the trillion, providing politicians with the cash to buoy battered economies with stimulus checks.
The return of inflation has changed all that. Central banks’ primary mission is to stabilize prices, so that the money in your pocket roughly holds its value. Money is supposed to be a store of wealth and a unit of account: When it ceases to perform these functions, the operating system of the economy crashes. Because of this inflation-fighting imperative, central banks now have to think twice before underwriting political expediency. Bailouts involve cutting interest rates and buying government bonds. Inflation control demands the opposite.
Britain’s crisis illustrates the pain of this transition. In announcing their program of unfunded tax cuts, Truss’s chancellor of the exchequer, Kwasi Kwarteng, behaved like a go-go start-up that spends money as though it were water, complacently assuming that venture capitalists will supply liquidity without end. With interest rates at zero, capital apparently costs nothing. Investors would pour money into almost any project because of the TINA principle: There Is No Alternative.
Well, now there is an alternative. The Federal Reserve has hiked interest rates to combat inflation. Investors can stash their cash in U.S. mortgage bonds and get paid 6.7 percent, more than double what they would have gotten just a year ago. Like a start-up that burns money without generating revenue, a government that cuts taxes without squeezing spending can no longer count on the markets’ indulgence. RIP TINA, and hello MARA. Markets Are Rational Again.
But around the world, politicians have yet to adjust. As the Economist noted recently, leaders responded to the 1970s energy crisis by telling people to wear an extra layer and cut fuel consumption. “We aren’t going to starve”, West Germany’s chancellor observed calmly. Today, by contrast, politicians are hurling subsidies at consumers and suspending gas taxes. When the oil shock hit in 1973, the real value of Britain’s benefits bill hardly changed. This time, the government is throwing 6.5 percent of gross domestic product (GDP) to shield citizens from fuel costs.
And the bailout reflex extends beyond the energy sector and Europe. In the United States, the government guarantees bank deposits and mortgages, subsidizes health care and more; now President Biden proposes to spend hundreds of billions of dollars to cancel student debt. Adding up the government’s contingent liabilities, the Economist calculates that Uncle Sam is on the hook for debts worth more than six times GDP and that this ratio has shot up lately. In 1979, the bottom fifth of U.S. earners received means-tested benefits worth about one-third of pretax income. By 2018, it was about two-thirds.
Thanks to the 23-year inflation vacation, rich societies have grown used to the idea that government can fix stuff. This is still true in significant ways — the Bank of England backstopped government bonds last week, albeit on a time-limited basis. But to preserve their ability to help in extraordinary times, politicians must exercise restraint in ordinary ones. The inflation vacation is over. Adjusting is going to be painful.
Sebastian Mallaby is the Paul A. Volcker senior fellow for international economics at the Council on Foreign Relations and a contributing columnist for The Washington Post. He is the author, most recently, of "The Power Law: Venture Capital and the Making of the New Future”, published in February 2022.