Kopi Time E086 - OMFIF’s David Marsh on the Sterling crisis and UK

before setting up this think tank. He worked for city merchant bank robert, Fleming corporate finance, boutique, Hotpoint, german management consultancy, droga investment from London, Oxford and many other places, including almost two decades in journalism spending most of that time with the Financial Times. David has written six books, the last of which is co authored with William keegan and Richard roberts is titled Six Days in september black Wednesday Brexit and the making of europe.

I think, given what has transpired lately, David, that book needs an additional chapter. Welcome to Covid Time. David.

from peak to trough. I have a few questions on the ongoing episode for you first, your assessment on the policy actions and the economic conditions that have led to such massive depreciation of the sterling,

in 1992. Also, the government was warned the mistress's government and only a short time in office was warned before the so called Mini budget on 23 September that this could lead to a big market problem. They were told by advisers in writing that they would need to watch out about the market reaction, but they were arrogant about this and they failed to take onboard

those warnings. So some of this is part of the general rather difficult background we have with the Russian war and the strong dollar, but I would say 80% of this is a self inflicted wound.

of her advisers. She caused the main official in the Treasury Sir tom Scholar, to be sacked on day one of her tenure. This is unprecedented. That this was at the beginning of september normally, if Prime Ministers don't like the top civil servant in the treasury, they find a way of just lodging that person over time, but not on day one, This was two days before the queen died. And so it added to the sense of great Change and dislocation at the Bank of England just a

day ago. From the time when we're doing this podcast did issue a very strong statement about the reasons why it brought in this emergency action which took place at the end of September the famous shoring up of the Gilts market and it justified this action on the grounds that they would otherwise have been a huge dislocation with pension funds, about 50 billion sterling worth of gilts had it not been for the intention, which they made saying that they would buy up to

five billion of guilt today over 13 working days. That will run out on the 14th of october and they're really staying in that letter and there's very strong divergence between what the treasury is doing under its new leadership, basically led by truss and the quasi tang the new

charts of the exchequer and the bank itself. So this is very dangerous for markets when you have the feeling that these two economic actors at different ends of town, one in the city, one in Whitehall operating on different principles and with a different set of philosophies. This is really very bad news for markets.

I think they'll have to be other measures which will basically reverse some of the moves in the mini budget. The point is the catastrophic fiscal position of the U. K. Has not fully been revealed because the Chancellor and the Prime Minister didn't want the Independent office for budgetary responsibility to come out with its forecast at the right time. Which were operating a bit in the dark. But we do think that these unfunded tax cuts are going to be extremely difficult to finance and can only

be financed at higher gilt prices. Hence the big sell off in the government bond market that we had at the end of september which has only been partly reversed. So if you're looking for changes tomorrow as you're saying then either they have to resend some of the tax cuts and raise more money by tax or they have to do a great deal more public borrowing that much you which is bad for the economy or they have to bring in some very unpopular and very socially divisive cuts

in public spending. Those are the only three things they can do. And the cuts in public spending. Not only would they be unpopular, they would probably also be bad for the economy as well. So either way in all these three areas they're looking at a pretty difficult position. I think they'll have to do a mixture of all

these things will be higher interest rates. There will be some cuts in public spending but not as regressive and especially divisive as some of the rather bad indications have have been telling us and they will have to be some rises in taxes which goes against the government's philosophy. So in all these three scenarios, we're looking at political and economic problems ahead for Britain.

what went wrong for this particular juncture? I mean you have alluded to the lack of transparency being one that the forecasts were not available. People have been acting in the dark, but then there's also the cyclical weakness. I mean, has this been one case of bad timing and bad communication as opposed to the substance being fundamentally bad.

think that's the salient difference. The americans can as we know funds their deficits through the famous exorbitant privilege that is accorded to the world's number one reserve currency Britain doesn't have that privilege. So it's a strange paradox that we have mr quan Teng. He seems to believe that sterling is still the world's number one reserve currency and people will therefore fund the deficit without tears.

And that clearly isn't going to happen. So I think it was colossal arrogance actually on the part of trials and squatting and some of their advisors or some of the advisors did as I say, counsel very strongly against this plus grade poor timing plus an unwillingness to even talk to some market participants beforehand to gauge the reaction. So it is hubris and ignorance. I'm afraid to say pretty bad combination.

For greater shocks, about to hit global markets.

of the past British episodes. So we we saw the 1976 crisis when Britain had to go to the IMF we had the 1967 devaluation of sterling, which was the only the duomo of years and years of problems of battling against the current account deficit in the time of Bretton Woods. So it's confirming all that past history tells us that finance can be very unstable if you get your sums wrong and if you lose confidence, the the worry of course is that, as you say, Britain is from a market point of view,

Britain is an important trading place. It's still without a doubt, the number one financial trading place in europe, despite Britain having left the european union now a couple of years ago, after the

referendum in 2016. And Britain has taken over from Italy now as being the one big source of instability on the european markets and it's a bit rich really for a conservative Prime Minister, Liz truss who now comes in pledging some kind of stability and go for growth strategy that she has become singlehandedly the number one source of risk and instability on global financial markets. This is not a good position for a

Conservative Prime Minister to be in. So I think it's more telling us the cautionary lessons of the past are justified rather than a pointer to all kinds of unrest in the future. Central bankers have been saying to me partly in jocularity, partly in sorrow that what Liz truss and quasi squatting has served up is actually very solitary for the new italian government, which we think will be led by joe joe Georgia maloney, the far right leader because it shows her what

not to do. And I'm absolutely sure that Georgia meloni and her advisers are looking at this trust and saying, look, this is absolutely the wrong thing to do whatever we do. We have to maintain the trust on financial markets, We have to do what we can to show we're going

to be good corporate citizens. They may actually have different views altogether, but outwardly they will be showing a good deal of conservatism and a good deal of orthodoxy, not least to curry favor with the creditor countries of europe who are supplying funds for italy and I'm afraid to say that mrs trust, forgot that she is a person who relies on the markets to fund the current accounts ever said Mark Carney, the previous Central black Governor coined the

phrase because I don't really agree with. But he said Britain relies quotes the kindness of stroke quotes to fund its current account deficit. I don't think it's kindness is because people think that they can make a yield in Britain. But she's she's gone about it totally in the wrong direction and she hasn't realized she's got a deficit to finance. You've got to be nice to the creditors, you shouldn't be arrogant. And that's the lesson that she's failed to comprehend.

I hope she does understand this actually. I do hope that the last few weeks have been solitary.

policy coordination. Do you think that the lesson from the past few weeks would galvanize you know, better collaboration.

So she's well known for her flexibility. She reminds me a bit of Groucho Marx, he said, I'm a man of many principles and if you don't like the ones I've got now, I have got other ones. So it could be that there will be a U turn in her philosophy. I also think it's good that the Bank of England again, as she was a time in a slightly backhanded way, has gained a bit of

solidity and credibility through this. Andrew bailey, the governor, he's been in office now since the Covid crisis started, there's not been a very happy time for him over the last 2.5 years and there'll be people gunning for him. He's not been without blame. I have to say there have been some mistakes by the Bank of England, but he's sitting now in a more comfortable position because she's undermined everything else. We have a new monarch.

We have a new prime minister, we have a new permanent secretary of the treasury when they get around to appointing that person. We have a new Chancellor of the Exchequer. So I don't think they're going to change or try to force out the Governor of the Bank of England at the same time. He's got another five years to go in his mandate and I think he'll be around. So if you want a silver lining, you might have a bit more institutional stability, particularly the Bank of England.

And they may be in a better position perhaps to influence policy, but I still think it's going to be very, very rocky road, I'm afraid.

domestic economic and political requirements. Does that parallel work for the U. K. Today?

And I do think that those emerging market economies who have now had to suffer quite a large depreciation, they'll be importing inflation and they also have to pay much higher interest rates on their dollar debt without a doubt, that's going to cause huge dislocation for the emerging markets at a time when energy prices have been high, although they do seem

to be coming down a bit now. So I think that has been the main issue shades of 1997 probably not because we don't have fixed exchange rates in the way that we did day factor or day jury in 1997 1998. But there has been a very strong devaluation of some of the emerging market currencies and that will not bring holy good news. I also think over time that the rise in the dollar will impede american competitiveness and will lead to an overvalued dollar. We've not got there yet.

I think it might be partly because american manufacturing has got a lot stronger than we thought. Maybe that's because of technology as well as the Silicon Valley prowess has been transferred to the old economy part of America. That's why I, there's one I think relatively good piece of news which is that the american economy is more resilient than many people felt they are piling on the interest rate pressure somewhat late but better late than never at the Fed America is

standing up to that. So America is without a doubt showing good signs of being the world's leading economy. The problem is the rest of the world can't quite keep up.

substantially undervalued. Now, having experienced this depreciation,

government would like. That's going to probably increase the scale of the recession even though the government is talking about relatively shallow recession. And so the high interest rates I think will maintain sterling as a relatively attractive currency. It will not be good news for people who actually live in Britain and have to put up with these higher costs on mortgages and so on. But that's why I'm not fearing an

actual sterling crisis. I'm fearing more a recession that will certainly still further undermine the government and will probably lead to a labor Party victory at the general election. It may happen before two years, but the next general election is due in around two or 2.5 years, there may be an election beforehand. So this political instability I think will not be good news. But I don't fear a sterling crisis. I think the institutions as we have them will be ready to withstand that.

I do fear a lot of political vicissitudes. It could be though That a new labor government might actually end up being a more stable situation than the outgoing Tory government. We saw this of course in 1997 when Gordon Brown and Tony Blair came in and that actually led to quite a good constellation for several years. So you can't give up totally on Britain yet. But there will be big oscillations politically, I believe

of sovereign debt to manage. So two sets of questions first, how are the key institutions of european union standing up to the threat of war stagflation and risks of yet another debt crisis.

that that country is going to suffer more. So they brought in this famous transmission protection instrument which is supposed to mitigate this. This is actually rather akin to the Bank of England's special facility which they brought in on

the 28th of september this, this guilt purchase instrument. The difference is though, that the T. P. I hasn't been spelled out in any detail and it hasn't been used with the Bank of England has use It's a special instrument that it unveiled on 28 September although it hasn't used much of it quite cleverly, I think it's not used that much. So there's some weapons in the armaments in the arsenal of the PCB that

is not used yet. I don't think the T. P. I will be used because it's quite difficult for Italy actually. So I I believe therefore that the spreads will continue to rise in Between say Italy and the German bonds at the moment, they're about 2.4% points. I think they'll go a bit higher there creep up slowly without a real sense of crisis. I believe they will be relatively shallow recession in Germany, don't forget Germany's actually throwing the kitchen sink at this.

It's using its balance sheet as well. Not in a very communitarian way. There's been a lot of criticism of the 200 billion euro package that Germany brought in to safeguard the consumers over this energy crisis. And yet they have stopped so far a price cap for energy for europe as a whole is very much a Germany first policy, I'm afraid to say. And you've seen this on many occasions in the past, Germany does have a pretty nationalistic or certainly a national

way of doing things. And this is not good news for the rest of europe. So the Bundesbank would like to have still higher interest rates and they'd like to start quantitative tightening. That will not happen because they are worried about italy we'll probably still have yields and interest rates in real terms at negative levels next year. I believe in europe, the CCB will not

slam on the brakes big time. They will not be as aggressive as the Fed that will have to outcomes one, it might mitigate the scale of the recession because they will not be so uh aggressive in monetary tightening as the americans. And I also think we'll have a relatively weak euro, which could also be quite helpful for the economy. So I don't foresee a huge crisis in europe, I think they'll do just

about enough to muddle through. But all the old question marks that we've had about monetary union ever since the beginning. You know, the lack of real political union at a time when you've fused together the monies and I've got just one single currency, all these old question marks will still be with us, I'm afraid it will be a case of further muddling through and a sense that monetary union is still incomplete. And and the sense that without a lot of permanent crisis fighting,

the monetary union could break up. And that's again at a time time of war in Ukraine, not a comfortable position, but the very fact that there is a war in Ukraine means I think that the politicians and the central bank will go the extra mile to put the sticking plaster over this unfinished edifice of monetary union. So I don't actually foresee it will break up any time soon, but it does remain a long term question mark.

payments going throughout the euro area. So through these mechanisms there will still be a lot of sticking plaster in place. I think the Germans will have to show a more community minded attitude actually over energy and they will have to also probably advance more guarantees and more loans of a europe wide dimension following on from the next generation EU fund that was agreed two years ago. I think there has to be more such super national borrowing mechanisms

to help europe through the crisis. And that will not please the purists who say that the EU needs to have a proper political underpinning and you can't keep going on through these ad hoc measures but that would that would involve treaty change to change the whole bedrock of the european union and actually to make it a proper union making a political union at

the moment. There's no likelihood of that happening in any country that no country would wish to go through the whole upheaval of a treaty change which will lead to referendums. Many countries will have to lead to constitutional changes in Germany as well as other places. So we'll continue with the sticking plaster but it'll be pretty messy. I would say

Obviously I'm not a meteorologist, but I'm just thinking that global warming is starting to have an effect and therefore the increase in energy prices will also encourage Germans to switch off some of their heating and not use as much energy as well as the relatively mild weather. And I'm also foreseeing some national measures to help.

They're certainly not going to go back to this idea of this fiscal break, which they've got in the constitution, they will override that they will certainly have deficits next year in Germany. And also they've discovered as all the other countries have discovered the wonderful way of doing mechanisms outside the budget. This special fund for the defense industry, the 100 billion shots unveiled just a couple of days after the Russian invasion plus this new 200 billion, a lot of that

would be financed off budget? The Germans of course are digging a hole for themselves because they've always been the ones who are telling people they should stick to the rules. But sometimes the Germans make rules which are really for others rather than for themselves. So again, this may not be perhaps the right example to give to mrs maloney when she comes to power. The Italians are very good also inventing all sorts of inventions and all

kinds of subterfuges outside national budgets. We're going to see a lot of that. So tomorrow you and your colleagues who look at all these things, you have a lot of different budgets to study not just the national budget, but the off budget mechanisms in lots of european countries. That way, I think Germany will actually escape a really severe recession. And I think that's relatively good news. I have to say

down for weeks, they'd have to furlough workers. I'm not saying that they would be civil unrest, but there clearly would be demonstrations in the streets about this in in Germany, the german, the german government would throw money at it as it always does, but this could certainly lead to a breakdown of the coalition. For example, in that worst case scenario, any thought of tightening would have

to be put on ice. The balance sheet would continue at a very, very high level and Putin would clearly feel that he's won a major victory. If large girl hardship was to take place in Germany and Bsf were to close down his plant, say for three months, which it might have to do in, in the worst case scenario. And there is a parallel action. It was 1992 here because several people in 1992 said,

europe is playing paying the price for german unification. The Germans had to stick up the interest rates in 1991 1992 which did lead to the pounds ejection from the E R. M. And of course Italy left on the same day as the pound on the 16th of september 1992 and you could mount a case now if you wanted to, If you wanted to be relatively harsh on Germany, you could say that Europe is paying the price now for German misjudgments because Germany did undoubtedly put too many of

its energy eggs into the Russian basket over the last 20 years, 55% of all Germany's gas imports of all its gas use came from Russia on the eve of the invasion. And there's been a tremendous effort by the Germans to make up for that by taking gas from other countries, driving up world prices actually. And some of this is quite unfair. It certainly means that there's less gas to

go around for everybody else, particularly the emerging markets. So you could say there's a parallel between German misjudgments over unification and having to finance a lot of this through higher interest rates in 1992 and misjudgments on the energy side here. So again, we come back to the parallels. It's not a perfect way of saying the two episodes are similar, but there are certainly some parallels and some convergences. I would just like us to think we can learn from some of these parallels.

Half of the French nuclear power stations are not operable at the moment because of some problems over corrosion, engineering problems, lack of water during the very hot and dry summer. So there's big energy problems in in France as well. There would be a good opportunity for more gas sharing out also using some pipelines from Spain Spain has got a lot of liquefied natural gas, but that seems to be blocked by various disagreements and squabbles within the european union.

So, I would like to think that there could be much more of an energy union between say Italy Spain France, Germany and even the UK using the interconnector that we have underneath the english channel for nuclear exports from France to Germany sorry, from France to the UK at the moment, France isn't exporting electricity because of these problems I've mentioned in the in the nuclear side. So I'm not wholly without any kind of confidence in

the future here. There could be a new angle here to push forward an energy union in Europe and I would hope that over the next 1-2 years. We will see this will see me More efforts to share energy. Will see more efforts to save energy. We will also see more efforts to go further on the renewable energy side. Despite all the problems

we know about that, it is relatively cheap. So looking at the longer term, I'm relatively hopeful it is getting through not just this winter, but the winter 2023 2020 for that's going to be problematic. I think Putin has without doubt underestimated the resolve of the West to stand up to the aggression both militarily. He's probably been surprised by that. He's been surprised by the incompetence of his own army as well. But he's probably also been surprised by relatively large amount of economic

solidarity despite the problems I've mentioned just now. I I very much hope that that will continue. And again, I I do think that the sorry state that Britain is in showing what happens if you go on a go it alone? Rather arrogant path. I would very much hope that that could have some positive impact on the rest of europe and maybe over a longer period of time will have some positive impact on Britain at all Britain

as well. I'm not talking about Britain rejoining the european union, but I'm very much hoping that there'll be more of an effort by the U. K. To go into lockstep with France, Germany Italy and spain in coming years,

be more of a blip. I'm obviously not expecting and certainly not hoping for an escalation further escalation in Ukraine. So a lot of these hopes for next year are predicated on a relatively orderly path of the war if you can use those terms. Because I know a lot of the war is absolutely horrible. So we shouldn't start thinking of this like a like an economic operation. I'm thinking the war will will

carry on for at least another year. But I'm very much hoping it would lead to a continued escalation which will mean that nuclear weapons get called in in some way, which clearly would put an end to all our hopes in in very many ways. So I'm relatively hopeful there will be more international cooperation a lot depends on the midterm elections of course in the United States and whether or not we

see further polarization and a return to trumpism. So I'm not catastrophically gloomy about the world economy, but there are a lot of caveats in what I've just said,

tight for the rest of the world. And assuming the, the American ideas of some kind of oil price cap to work, then I could see that we could have a positive inflation shock in the United States towards the end of next year. I think that European inflation will

be 6% next year. So we will not see Any very rapid fall in the inflation rate in Europe, but it will not continue at the figures difficult in some parts of the European Union, in the Baltic states, we do have not just double figures, but we have above 20%.

So based on a feeling that there will be a greater degree of orderliness in the energy markets and some of the commodity prices have anyway been starting to fall for several months and then we will see some fall in inflation but there's no way that the C. B. Can get back to its target of 2% by 2024 I think we'll be talking about 6% next year. And maybe if we're lucky 3 to 4% in 2024 For Europe and a bigger decline in inflation in the

United States. And the continued high inflation rates in Europe could have some mitigating effects on Italian debt because there is one classic way of inflating away the debt, if Italy can manage to grow at 2-3% over two years and therefore they continue to have an inflation rate of say 6% then they will have a G. D. P a nominal GDP rise let's say something like 15% over the next two years. That's quite a good way of inflating away

some of the excessive debts that they have. This is not something that european central bankers like to talk about in public because of course it goes against the grain to say you're using inflation to lower the debt problem. But behind the scenes european central bankers are saying sort of that that could be a positive side effect of high inflation. It might make the debt position of some of the over indebted states principally. Italy a bit less parlous.

to sort of keep the debt deflation risk away. And so I think if I, for me, you know, I would err on the side of inflation as opposed to the side of deflation. Um David, you end your book, six days in september which I highly recommend to the listeners of Kobe time. Uh and you have this rather meta observation at the end, the tangled and tragicomic tale of black Wednesday provides a warning of how great plans can go awry.

So here we are in 2022, which great plans are at risk of going to rise today?

They saw the er m as being, if you like the front window or the waiting room for monetary union. So you had these two countries or two sets of countries doing the same thing for totally different reasons and that's what caused it all to come unstuck in the end and that is a danger. I think that people, for all kinds of political and economic reasons carry out a certain policy but for reasons of principle or philosophy which are entirely divergent and that is the

tangle that you get yourself into. Now I think if you take today's situation and say take global warming, there is a consent consensus that global warming is on the whole man made and there's a consensus that we should be doing all kinds of things to try to mitigate the rise in temperatures and that's why we have all these summits and so on. But people are actually doing all this for

totally different reasons. And of course they're reversing this. Now, look at the amount of money going into coal mining

these days. So that's how these great plans can go awry firstly, different countries doing what seems to be the same policy for a whole set of different political and economic reasons, some of which is very domestically driven and then plans getting upset by what Harold Macmillan, the former british prime Minister calls events events, dear boy events, events, getting in the way of grand plans, german unification got in the way of the plan to keep interest rates low, for example, in in

europe, and in the same way you have a war in Ukraine getting in the way of global warming efforts to counter climate change because people have been going back along the coal route now very extensively. So that's the danger.

I think that these plans do get derailed and I think the the fight against climate change is a good case in point that has been derailed by the efforts to get back into coal mining, not just in europe, but much greater extent in India and in china, that is going to be a real setback, I have to say, you could say over time, renewable energy will come and rescue us all. It's a relatively small part of the world, i. E, europe is making efforts on that, but look at India and china. So that's what I

mean about grand plans going awry. And it's I think goes much deeper than the relatively small issue about Britain and the er m 30 years ago, there's a much greater global action over climate change which is now being seriously put at risk by the perturbations we saw in the world economy.

So Britain and the er m that clearly is a sideshow is intellectually and politically and economically interesting, but it's a it's a footnote in history compared with the much more massive actions and the much more massive campaign to try to counter climate change and that is the big worry, I think that that that's going to be substantially undermined and diverted by the aftermath of the war

in Ukraine. So I just hope we can find a way of getting back on track on that question without losing too much time which would be causing the world irreparable damage.