On Friday, as the preparations for Labour Party Conference were, no doubt, in full swing, the Chancellor dropped his ‘mini-budget’ to the Commons and generated a financial reaction like we have not seen in decades. His pledge of unfunded tax cuts, reduced regulation of the banking industry, and limited support for the most needy caused a market collapse, including a decline of the pound to its lowest level against the dollar since 1985. Things are not looking good for the Truss Treasury, but why? Why did the pound crash and why does it matter?

The pound is a floating fiat currency. That means that it doesn’t have any tangible value beyond its role as a currency; it isn’t convertible or pegged, so you can’t cash it in for a guaranteed amount of gold, dollars, or any other asset. As a result, the value of the pound is determined by the purchases and sales of pounds in the UK and abroad, as well as the supply of pounds created by banks and the Bank of England. The pound crashed, therefore, because financial markets lost faith in the power of the British economy to repay its debts. They downgraded their opinion of all UK assets, though especially government debt (known as ‘gilts’ because the UK is old and confusing), and thus sold pounds and pound-denominated assets to move their money into other currencies. Liz Truss – a Conservative Prime Minister – managed to scare away investors.

The situation begs comparison with the ERM crisis of 1992, in which a speculative attack on the pound – similar to the one we’re seeing at the moment – caused the UK to leave the European Exchange Rate Mechanism, a precursor to the Euro in which major European economies pegged their currency to the Deutschmark. At the time, the UK’s currency wasn’t floating, so the Treasury and Bank of England had to use monetary policy to keep it at a fixed conversion rate to the other ERM currencies. Raising interest rates – the cost of borrowing – is a staple way of a currency crisis because it causes investors from abroad to want to move their money into the UK so that they can take advantage of the higher interest rate. Investors see they can make a higher return in the UK and thus decide to invest here. Consequently, loss of confidence by investors caused the Bank of England to raise interest rates. Such a move reduces the pressure on the pound, potentially stabilising it, but generally pushes the economy into recession. In 1992, despite the Bank of England pledging to raise interest rates to an eye-watering 15% and the Treasury bankrolling the pound to the tune of around £3bn, the UK could not remain within ERM. The UK left the ERM, causing serious short-term damage to the UK economy and trashing the Conservatives record on the economy. Today, people draw a causal line from the sterling crisis to Labour’s landslide at the following election.

To be clear, we are not quite in that situation at the moment; the pound is not pegged to anything. We don’t have a fixed target for what the pound must be, and it isn’t a short-term disaster that the pound has fallen in value. However, exchange rate fluctuations are a problem. Firstly, because it makes British imports more expensive, contributing to inflation. With the cost-of-living crisis where it is now, we can ill afford the price of everything from outside the UK to increase. The Bank of England may well be forced to raise rates, both to sure-up the currency and tackle inflation, but this will slow growth even more. Secondly, currency instability will discourage investment in the UK. If firms and investors can’t predict what their investment will return (in foreign currency), they are unlikely to pledge the capital we need on the markets. This, sadly, includes government debt, which Liz Truss and Kwasi Kwarteng’s ‘mini-budget’ requires us to gather in spades.

Partly because of the cratering of the pound, then, and partly as a direct result of the Treasury’s announcements, the borrowing rate for the UK Government has also increased. Since we are facing an inflationary crisis, the Bank of England is also likely to further hike domestic interest rates and tighten their own lending to the government, pushing the interest rates on gilts even higher. All of this will make the tax cuts pledged by Truss even more costly and may also damage our ability to borrow for important investment projects in addition. Contrary to a decade of Tory orthodoxy, the UK does need regular access to credit markets, because governments require a flow of liquidity in order to build successful and growing economies. Indeed, the choking off of credit may well take some of the blame for the terrible growth we have seen during the last decade.

Liz Truss’s ‘Black Friday’ was probably not a political moment on the scale of the 1992 ERM crisis, but it was an economic catastrophe. The issues we face in our economy today are as grave as they have ever been – Britain now faces the threat of relegation from the top economies of the world. If we don’t tackle both the productivity crisis that has plagued us for a decade and the terrible consequent wage growth, we will see living standards decline and our economy locked into a long-term worse growth path. Don’t let anyone tell you that they can’t trust Labour with the economy. Our record involved 10 years of uninterrupted growth, the longest in modern British history, followed by a financial crisis created abroad and tackled admirably at home. The Conservatives had the economic winds at their back from 2010 to 2020 and they have delivered nothing. 

Looking forward, our prospects are not all terrible, however. The UK is an English-speaking nation in an increasingly globalised world. We specialise in services, the West’s major growth sector, have expertise in important areas like bioscience and research and development, and have a world-leading education system. Despite Brexit, we remain strategically located at the periphery of Europe, with easy access to a valuable and enormous market both for labour and exports. Trade will go ahead, despite unnecessary fictions, and our current economic isolation can easily be remedied to fashion a much better and closer relationship to our major trading partners. We should be one of the fastest-growing nations on earth. As Kwarteng and Truss continue to mutilate our economy, stamping on each and every promising shoot of growth before it has the chance to emerge from the soil, we should not lose sight of these long-term opportunities. The economy is in a dire state, but  it is nothing that a Labour Government, or perhaps a few Labour Governments, can’t fix.

Matt is the Vice-Chair of the Economy and Finance Network. He is currently a postgraduate Economics student. He’s from Merseyside, Labour’s true heartland, and writes frequently on a range of economic and political issues.

His interests in Economics focus on microeconomic theory and Public Policy, and his politics are characterised by a near-pathological obsession with returning Labour to government. He tweets at @matthewoulton.