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Consider the following statement about the relationship between markets and policymakers: “(They) are separated by light years of distrust and misunderstanding. But market realities have the last say-so. Wall Street votes with the upward or downward movement of stock and bond prices. Their reaction ultimately will make or break a President’s program.”
These were the words of Stuart Eizenstat, advisor to President Jimmy Carter, about the hard lessons learned about his failed budget in early 1980 (he had to retract it) that could have been a warning to Prime Minister Liz Truss and chancellor of the Exchequer Kwasi Kwarteng. By announcing an overreaching budget–which has good intentions and good elements–they behaved as if we were still in a pre-COVID era where economic slack and sluggish inflation gave license for unfettered tactical stimulus.
In reality, the tactical stimulus toolkit that politicians have used so prolifically is in flux and now faces constraints not unlike the struggles that President Carter faced. The veto power of markets can easily offset the stimulus enacted by politicians, voting down policy efforts by tightening financial conditions through higher rates, lower currency, and lower stock prices.
The market rout in the U.K., an extraordinary rebuke by investors of a business-friendly but overreaching fiscal program, serves as a reminder that the reality of stimulus is changing before our eyes. This constraint on stimulus ability is neither confined to the U.K., nor is it limited to fiscal policy.
An overreaching budget assuming old rules
The U.K. economy is experiencing the worst of both U.S. and Eurozone problems. Like the U.S. the country has a problem of broad-based inflation that has pushed the Bank of England’s rate path to U.S. levels (and now higher), while the Eurozone has narrower inflation and therefore less headwind from ECB policy rates. Like the Eurozone, the U.K. is experiencing an excruciating energy shock that far exceeds the energy headwinds in the U.S.
Having to navigate the worst of both sides of the Atlantic, the incoming government was always going to address the cost-of-living crisis with fiscal policy. Indeed, when Prime Minister Truss announced a significant fiscal lift of capping household energy bills at £2,500 over the next two years markets didn’t go haywire.
However, when chancellor Kwarteng outlined his massive tax cuts, markets fell of a cliff–10Y gilts spiked nearly 100bps in the aftermath and, at one point, the pound was down 9%.
Markets viewed energy price caps as a political necessity, but the new budget has pieces which topped expectations of profligacy and fiscal largesse, including the (highly regressive) scrapping of a high-income tax bracket. Markets would likely have ignored these tax cuts a few years ago–but when inflation is around 10% and economic potential is being stressed, they fear policies that push demand higher and threaten to stress the inflation regime thereby pushing monetary policy even tighter.
Though the size of the new budget is profligate, the intent of this fiscal efforts is not wrong-headed. First, protect consumers to soften the looming recession and, second, incentivize investment to push the medium and long-term growth potential higher. A smaller package, focused on essentials, without regressive giveaways, could have worked. What is wrong-headed is ignoring the new realities of constraints on stimulus.
Two lessons from the Carter budget
President Carter might have told Kwarteng that despite a desire to be bold, any plan must be acceptable to markets. If market makers use their veto powers by selling gilts (thereby pushing market rates higher), Sterling, and British stocks, any positive stimulus of the fiscal policy may be offset by the resulting tightening of financial conditions.
And while low taxes may tempt investment, an unstable currency and financial volatility may frighten it away. Not to mention the risk that the plan may not survive politically. Though chancellor Kwarteng said, “no comment”, the first lesson of constrained stimulus ability is that market reactions to policy cannot be ignored.
The second lesson is about the importance of the structural anchoring of the inflation regime. Carter’s budget was not nearly as dramatic as the U.K.’s (in fact, the market fire was triggered merely by a new government estimate of the deficit) but the U.S. inflation regime was already broken in 1980 with inflation expectations that were unanchored. The administration had to withdraw the budget and resubmit it with cuts.
Kwarteng’s problem is quite the opposite: the U.K. still enjoys the luxury of anchored long-term inflation expectations, but it is precisely the profligacy of his budget that calls into question the durability of such hard-earned expectations. Markets are right to be this vigilant. Recall that the initial policy of energy price caps was not vetoed, but in a world with structural inflation risks there is a big difference between necessity and profligacy.
The future of the stimulus machine is in flux
In March, we argued in these pages that the stimulus machine was “sputtering but not broken”. Our key concern then was that–with inflation running high–the tactical use of monetary policy was constrained and deprived a slowing economy and faltering markets of rate cuts that were once taken for granted. Yet, systemic stimulus to backstop the economy in times of crisis would still be possible.
What has changed? We view the U.K. rout as evidence that the constraints on tactical stimulus have clearly broadened beyond monetary policy to include fiscal policy. That was already indicated by President Biden’s trouble to pass the Build Back Better Act, a large spending bill focused on broad social programs and the green transition, due to concerns over inflation in his own party.
However, we still believe that structural stimulus capacity remains. If the U.K. was to face an existential systemic risk tomorrow, akin to the COVID pandemic, markets would be unlikely to make use of their veto power.
Philipp Carlsson-Szlezak is a managing director and partner in BCG’s New York office and the firm’s global chief economist. Paul Swartz is a director and senior economist at the BCG Henderson Institute in New York.
The opinions expressed in Fortune.com commentary pieces are solely the views of their authors and do not necessarily reflect the opinions and beliefs of Fortune.
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