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David Cameron Misreads the UK's Advantage

David Cameron
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David Cameron

One reason I have no confidence that Europe will be able to resolve its debt/monetary crisis is that so many European policymakers do not understand their own public financial systems.

In particular, few seem to grasp how monetary policy works in an economy with central bank-controlled fiat currency.

The latest evidence of confusion comes from David Cameron, the UK prime minister.

“Those who still argue for an abandonment of our deficit reduction plan should reflect on the journey this country has taken. We went into the bust with the biggest structural deficit in the G7 and came out of it with a deficit forecast to be the biggest in the G20. It is thanks to the credible plan this government has set out that today we have market interest rates of just 2.5 percent — half what they are in Spain or Italy,” Cameron writes in a piece for the Financial Times.

What’s wrong with this? Well, it reads as if Cameron has forgotten that the main relevant difference between the UK and Italy/Spain is that the UK isn't a part of the euro zone — that is, it isn’t on the euro. This has worked to its great advantage because the UK government doesn’t need to get permission from the Germans to run a monetary policy that won’t bankrupt it.

As a result of its monetary independence, the UK is not at risk of defaulting on its pound-denominated debt. This means it will never be Greece, which cannot be said for Italy or Spain.

So with global markets everywhere going into high volatility mode, countries with no risk of involuntary default — U.S., Japan, UK — see the prices of their bonds fall because of a flight out of risk assets, especially sovereigns with real default risks. The idea that plummeting rates on risk-free bonds indicates confidence is just bizarre.

Paul Krugman gets this right: “All signs point to falling rates because of falling, not rising, confidence: Nobody expects the countries with their own currencies to default, nor did they ever, but they now expect short-term rates to stay low for a very long time thanks to a weak economy.”

The things to understand is not that British austerity is necessarily a mistake. British government spending does need to shrink; it had grown so much that it created serious problems for the parts of the economy not funded by government. The point is that austerity’s short-term effects will be greatly ameliorated by the fact that the Bank of England can provide some relief. The central bank can encourage additional private spending and investment even while the government shrinks.

This is a path unavailable to Italy and Spain right now because they are locked into the euro.

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