Money & Markets: The UK’s financial woes were down to the US Federal Reserve

Engineers will be very familiar with chaotic processes. In some special types of configurations, tiny differences in starting points can lead to wildly different outcomes. Small inputs can lead to giant unpredictable results. Poincaré predicted planet trajectories and won a prize, only to find a mistake in his work and realise he had actually proved it was nigh on impossible to predict them through what was to become the foundation of Chaos Theory.

It turns out that economics is one such system of moving bodies and while you might have a theory that works for now or perhaps one that fits the soon to change cyclical observations, things will decouple and land everyone in a fundamentally changed economic system.

The old joke goes, ‘If a butterfly in the Sahara can cause a hurricane in the Gulf of Mexico, someone needs to find that butterfly and swat it.’

Apparently, some people are fooled by randomness but in reality, most have no idea what it is all about at all.

Just when it is considered that the task of managing an economy has been cracked, some other strange attractor gets to work and the rules change enough to produce a crisis.

There is no permanent debugging of an economy; just like a machine it wears, goes out of tolerance and breaks.

As I write this at the beginning of October 2022, it appears we are heading into one such crisis event.

Last week the Bank of England had to step in to rescue the government’s long-term bond because it was crashing. The statement about using £4,000 per average family to “protect UK financial stability” has probably not been well understood. After all, a little bit of instability is a common experience to most people and it’s not so bad. However, what this meant was the quantitative easing action, whereby the Bank of England galloped in and loaded up on the malfunctioning government bonds to stabilise its price, was to prevent financial Armageddon. If a country’s government debt spins out of control, the result is economic devastation.

In the way these stories are told it was all down to the new UK chancellor’s plan to try and pull the UK out of a quagmire of stagnation with tax cuts and energy subsidies. That is a simple explanation, after all such ‘brave’ speeches have been the lighted touchpaper of classic government economic mismanagement catastrophes in the past, especially the 1970s.

The truth, though, is that the Federal Reserve in the US came out four days earlier, raised interest rates by 0.75 per cent and stated they were going to blow up the US economy to get inflation down. This put the whole world on notice and on the edge of panic that dark days were ahead.

Here are some excerpts from the Federal Reserve chairman Jerome Powell’s statement and press conference, with my comments in brackets:

“Nonetheless, we’re committed to getting inflation back down to 2 per cent because we think that a failure to restore price stability would mean far greater pain later on.” (This is saying they will create lesser pain in the short term.)

“Higher interest rates, slower growth, and a softening labour market are all painful for the public that we serve. But they’re not as painful as failing to restore price stability and then having to come back and do it, down the road again, and doing it at a time when actually now people have really come to expect high inflation.” (Pain, pain, pain… and it was also made clear the Federal Reserve was going to over-egg deflationary actions to make sure they worked. They might be lying but a U-turn soon would be extremely difficult, and it will have to be soon to stop various economies and markets going into freefall.)

This is the underlying reason why the UK long bond imploded.

The old saying goes, when the US sneezes the world catches a cold, but the reality is when the US catches a cold the world gets pneumonia, so the stated plan to destroy demand to control inflation in the US and raise interest rates towards 5 per cent is terrifying. This has created a runaway dollar, which is crushing everything, including the British pound, in its path.

This runaway dollar is the key to what happens next because if the central banks, including the Federal Reserve, lose control of the dollar’s rise, there will be a full-scale global financial crisis.

The bottom line is, most developed countries are borrowed up to their eyeballs and continue to spend in an out-of-control manner. To fund this you have to borrow, and when no one will lend, you print the money and lend it to yourself, just as the Bank of England did last week.

Stripping away the niceties, the government (Bank of England) made money to buy the government’s bonds so it could continue to sell bonds in the future. Selling in the future to make up for deficits will either come from outside or again from the government itself via the printing press. That increase in money supply creates inflation and no amount of interest rate rises will reverse that monetary gravity.

But… but… people say, “You put up interest rates to lower inflation, everyone knows that.” The trouble is interest rates are sky high in Turkey and Argentina and so are interest rates in every permanently inflationary country. You can have high interest rates and print money, which makes inflation, so it is the increase in the monetary base that creates inflation and that is where the problem lies.

If the polity of the UK, Europe and the US continues to dole out new money to bail out whoever they think needs to vote for them, then the road to ruin is set. To aggravate matters, if the Federal Reserve is to be believed they have set a course to bring that to a head in the coming months because they can pull the rug on the whole process if they actually are prepared to inflict pain on the global economy to flush inflation out of the system.

Few notice a disaster averted, but one is certainly close. If the next weeks turn into the Federal Reserve versus the financially incontinent policies of the developed world’s polity then we are in for a very rough ride. If the US Federal Reserve pivots then we are in for a long period of high inflation. The latter seems highly likely but it’s hard to hear the Federal Reserve speak last week and imagine they can simply say, ‘Just kidding.’

It will not take long to find out.