UK economic plan was used in the US in 1981 — and it didn’t work

The British pound hit a record low against the dollar on Monday after UK Prime Minister Liz Truss, an advocate of the so-called “drip economy”, announced a sweeping plan for spending and cuts. taxes to rescue the British economy from recession on Friday.

Investors were stunned by the new government’s choice to institute its biggest tax cut in 50 years, while increasing government spending and borrowing with inflation approaching 40-year highs. Analysts at Citibank called the decision a “big unfunded gamble for the UK economy”. Markets plummeted on the news.

But Truss followed former US President Ronald Reagan’s suggestion in defending his actions. The government is “encouraging companies to invest, and we’re also helping ordinary people with their taxes,” she told CNN’s Jake Tapper last week, referring to Reagan’s “drip” 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 close to 10% and tight monetary policy had driven interest rates to over 19%. But like Truss, Reagan argued that massive tax cuts and deregulation would spur productivity and advocated a sweeping tax cut that was passed by Congress that year.

The Truss government points to this as proof that tax cuts do not necessarily raise prices. Inflation has dropped and growth has increased under Reagan, he 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 two years. Meanwhile, unemployment continued to rise.

Congress concluded that the tax cuts were unsustainable. With Reagan’s approval, he greatly increased taxes in 1982, 1983, 1984, and 1987.

A lesson from history: “When tax cuts are really too big to be sustainable, they are often followed by tax increases,” wrote David Wessel, director of The Hutchins Center on Fiscal and Monetary Policy.

And in the short term, for the UK, there is also a huge risk to its currency. The US dollar appreciated during Reagan’s tax cuts because it benefits from its status as a global reserve currency. A strong currency helps contain inflation and makes imports cheaper. Britain, seeing record drops in its own currency, does not have that advantage.

Bottom line: The British pound is likely to bottom out in three months, Goldman Sachs economist Kamakshya Trivedi wrote in a note on Monday. “But if politics [tributária] eventually not change course, we expect Sterling’s underperformance to persist longer,” he said.

This is bad news for markets around the world. S&P 500 companies that have a global presence are being hit hard by the strong dollar and the pound’s devaluation – about 30% of all S&P 500 companies’ revenue comes from markets outside the United States.

The last time Britain’s taxes were cut this much, there was runaway inflation, a massive jump in debt and, eventually, an IMF bailout. “It’s hard to see how the pound can recover from here,” Fiona Cincotta, senior financial markets analyst at the City Index, wrote in a note. “Investors are rapidly withdrawing from UK assets, and who can blame them?”

What does the pound fall mean for inflation and interest rates

We know that the pound sterling is falling against the dollar, but what does that mean exactly?

A falling pound is terrible news for an economy that may already be in recession, reports CNN journalist Julia Horowitz. As the value of the pound sterling falls, it becomes more expensive to import essential goods normally paid for in US dollars, such as food and fuel. That could add to decades-old inflation that is fueling a cost-of-living crisis for millions of families.

Then there are the rapidly rising borrowing costs for government, businesses and households. Investors expect Britain’s central bank, the Bank of England, will need to raise interest rates much more aggressively to control inflation.

A fundamental tension between the central bank and the British government can also spur volatility. While the Truss government wants to boost demand to stave off a recession this winter, the Bank of England is trying to cool the economy so it can contain faster price rises among the G7 countries. This friction will reduce confidence in the way forward.

“If markets still don’t trust the fiscal picture, I’m not sure how the Bank of England beats it,” said Mujtaba Rahman, managing director for Europe at consultancy Eurasia Group.