Former U.S. Treasury Secretary Larry Summers issued a grim warning after the British pound touched an all-time low this week: The U.K, he said, has lost sovereign credibility and risks triggering a global crisis with an "utterly irresponsible" tax plan.
Summers is a Harvard University professor who served under presidents Bill Clinton and Barack Obama. In a Twitter thread Monday evening, he said the U.K. government's sweeping package of tax cuts damaged the government's credibility as an economic superpower at a time when the world is already confronting painfully high inflation.
"I was very pessimistic about the consequences of utterly irresponsible UK policy on Friday," Summers said. "But, I did not expect markets to get so bad so fast. A strong tendency for long rates to go up as the currency goes down is a hallmark of situations where credibility has been lost."
The pound fell below $1.09 for the first time since 1985, dropping as low as $1.03 as investors weighed Finance Minister Kwasi Kwarteng's so-called mini-budget that included large tax cuts for individuals and businesses. The currency has since recovered slightly, hovering around $1.07 as of Tuesday afternoon.
"Sterling was given a boost by the Bank of England’s chief economist who made no bones about the need to raise interest rates in a significant way to steady the ship," said AJ analyst Danni Hewson.
Summers said that pound's reaction is more typical of a developing nation, not an advanced economy like Britain — the sixth-largest economy in the world.
"British credit default swaps still suggest negligible default probabilities, but they have risen very sharply," he said. "I cannot remember a G10 country with so much debt sustainability risk in its own currency." Credit default swaps are financial agreements designed to protect investors against default.
The plan from Prime Minister Liz Truss's administration last week included about 45 billion pounds ($49 billion) in tax cuts, which comes at the same time the British government is already spending more than 60 billion pounds to subsidize gas and electricity bills for households amid a worsening energy crisis.
The sudden sell-off in the pound and British bond markets comes as investors brace for more aggressive interest rate hikes from the Bank of England. The central bank's chief economist — Huw Pill — said on Tuesday that the tax cut and spending plan will be met with "significant" action from policymakers.
"We have all seen the recent significant fiscal news in the past few days," Pill said on Tuesday at a conference hosted by Barclays and the Center for Economic Policy Research in London. "That has had significant market consequences as well as significant implications for the macro outlook. It’s hard not to draw the conclusion that all this will require a significant monetary policy response."
Last week the Bank of England's monetary policy committee voted to increase Bank Rate by 0.5 percentage points, to 2.25%. The group next meets in November. The financial markets are pricing in expectations rates could rise to 6% next year.
Summers said he would "not be amazed" if short-term rates eventually tripled from current levels to above 7% over the next two years, given the growing economic concerns. He suggested the pound could continue to drop and eventually fall below parity with the euro and the U.S. dollar. Such an event, he said, could trigger a chain reaction around the world.
"My guess is that pound will find its way below parity with both the dollar and euro," he said. "A currency crisis in a reserve currency could well have global consequences. I am surprised that we have heard nothing from the [International Monetary Fund]."