In today’s Finshots we offer an oversimplified explanation on why the pound fell to an all-time low yesterday
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This story isn’t about the pound at all. This story is actually about British Politics. So let’s start with that.
A few months ago, the former British Prime Minister Boris Johnson stepped down after several key ministers and political appointees resigned in protest against scandals that rocked the top leadership. Liz Truss, a leader in the conservative party soon emerged as a front runner to replace Johnson. She narrowly beat Rishi Sunak in the final vote and became UK’s third female prime minister.
But her rise to power came at a very tumultuous time.
Take for instance, inflation. It’s rampant. According to a report in the World Economic Forum, “a single working adult living in the UK needs to earn at least £293 each week in order to reach the minimum standard of living. This is a 26.8 percent increase since 2021, when the average adult needed £231 per week.”
Meanwhile, the real value of workers’ pay in the UK has been falling at the fastest rate in 20 years. Meaning, if you discounted inflation, you’d see that UK citizens were being paid less each quarter. It’s staggering.
And there’s energy prices. Energy bills in the UK are expected to leap by 80% this winter. In fact, Britons are already paying some of the highest electricity bills in Europe and if this trend persists, they could soon leapfrog Czech Republic to the top. And it’s not a list you want to top.
Also, the U.K. is expected to be the worst-performing major economy next year. And cumulatively, this has precipitated what many are calling “the cost of living crisis.”
Bottom line — Liz Truss is up against the wall here. She has to beat inflation. Increase wage growth. Kickstart the economy. Deal with the energy crisis. And she has to do it all before the general election in 2024 (or she may have to pack her bags real soon).
It is a tall order.
Now what would you do if you were in this position?
Would you tread on the same path your predecessors did? Or would you try something radically different?
So far, the previous governments have adopted a very conservative approach in dealing with their finances. They’ve imposed high taxes while maintaining low deficits. Deficit means the difference between what the government earns and what it spends. Usually, governments spend more than they earn. Hence the name, deficit. But the question is — How high can the deficits go?
You don’t want it to go too high or you risk bankrupting yourself. But if the government doesn’t spend — on infrastructure, schools, public welfare etc, it could risk derailing the economy.
So in summary, Liz Truss has two choices as we outlined earlier. Stay put on the conservative path or do something totally different — Go all in, go aggressive.
And she’s doing the latter.
First, her government will be cutting taxes. The top rate on the highest earners will now move from 45% to about 40% and the lowest rate will move from 20% to 19%. They also reversed a planned hike in corporate taxes. Meaning, this government wants to put more money in people’s pocket and let them spend it on their own terms. The hope is that the increased spending could go a long way in rejuvenating the economy.
They also abolished a levy on the National Insurance Payments that was originally intended to fund the country’s healthcare system (the NHS). Earlier all employees were expected to pay 1.25% on their wages as well as income tax. But now, with the levy scrapped, they won’t have to pay this sum.
In all, the tax cuts are expected to cost the government £45 Billion. On the flipside, that’s £45 Billion saved for the citizenry. And the government will hope that they will spend a majority of this sum on productive means.
But that’s not all. The government will also cap energy prices, so households and businesses won’t have to pay a king’s ransom. This move is expected to cost the government another £150 Billion.
So in effect, the government is foregoing tax revenues and will be spending an exorbitant sum of money over the next couple of years. This will likely push the government borrowing to an all time high. And the borrowing will be used to fund the deficit — the difference between “what the government earns” and “what it spends.”
And this in turn explains why the pound is losing value. See, if people believe that a country could crumble under its own weight, then they won’t want to hold the country’s currency. In this case, the “British Pound.”
Think about it - What will you do with the pound? Where are you going to invest it? In failing businesses? In a country that's teetering on the edge of bankruptcy? It’s a loss making proposition.
And if you’re seeing a government heading straight into a brick wall, you will immediately sell the currency for something that's more stable (say, the dollar) and get out of there.
Which explains why the pound is tumbling in value. Right now, market participants i.e. those who dabble and invest in this stuff, don’t hold the British economy (or the country’s currency) in good stead. So they’re selling the pound and the excessive selling pressure is destroying its value.
However, if tomorrow, Liz Truss is proven to be a genius and the economy roars back to life, they will walk back on their position very quickly.
The pound will gain ground once again and all will be well.
That’s the story.
Until next time…
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