Taking a chainsaw to the magic money tree

The British economy is experiencing some serious turbulence—or an omnishambles, they might say across the pond—as investors give a big thumbs down to the UK government’s new fiscal plan.

What happened: The British pound fell to its lowest-ever level against the US dollar yesterday (before recovering slightly) and was down against other major currencies including the Canadian dollar.

  • Yields on the UK’s benchmark five-year bonds rose above those of Greece and Italy—a worrying development, as higher yields are a sign of less investor confidence in a government’s financial stability, and those two countries aren’t known for inspiring investor confidence.

Why it’s happening: Investors think the UK government’s costly new economic plan, which includes the biggest tax cuts since the 1970s, will make inflation worse and overload the public debt.

  • The UK government is betting that lower taxes and deregulation will add enough economic growth to offset the cost of the plan and make inflation manageable.
     
  • But markets clearly do not agree—investors are betting that the hoped-for growth will not materialize and tax cuts will make inflation even worse, forcing the Bank of England to raise interest rates even higher.

What they’re saying: "It's effectively the market saying, A, we don't believe in trickle-down economics and that growth is going to miraculously occur, and B, you see that magic money tree you just planted—we're taking a chainsaw to it," UBS Global Wealth Management chief economist Paul Donovan told the Wall Street Journal.

Why it matters: The ups and downs of the British economy and pound seem remote, but this episode could be a preview of things to come in more countries as governments try to adjust to a world of higher interest rates and tighter monetary policy.