The bond vigilantes are back
All-important mid-term elections approach in the USA. Xi carefully manoeuvres his way to become President for life. Putin launches more missiles. Yet, all eyes have been on the political shenanigans and economic fallout in a small backwater island off the mainland of Europe. It may be easy to poke fun at the UK Conservative party, or take a classic left wing stance and criticise its policy errors over the past decade. However, the rise and fall of ‘Trussonomics’ is a warning to many other governments that for too long they have papered over cracks in their economic decision making. Indeed, the tensions and divisions experienced in the UK could easily be repeated in many other parts of the world.
If we stand back and look at the decisions made in September by former Prime Minister Liz Truss and the previous Chancellor, Kwasi Kwarteng, then their analysis was sensible but the decision making poor. The UK has become a slow growing economy. The cumulative effects of the 2008 financial crash, then exit from the EU after the 2016 Brexit referendum, then the 2020 Covid shock, have all weighed on long-standing problems of low levels of investment and R&D, weak employee and managerial skills, plus poorly managed infrastructure projects. The result has been poor productivity by international standards, as analysed in coruscating detail by such academic heavyweights as Andy Haldane at the Royal Society for Arts, Manufactures and Commerce.
Truss and Kwarteng planned a dash for growth, a political roll of the dice to limit the current recession, even engineer a boom before the next general election by January 2025. In the event, financial markets rebelled. This was partly due to the size of the unfunded tax cuts, which would ultimately have forced the Bank of England to hike interest rates even more aggressively, with a subsequent jump in bond yields putting pressure on the hedging positions of many UK pension schemes. The second concern was the nature of the open ended programme to restrain energy bills for UK households. Cost estimates varied but £100-200 billion was widely accepted, even before another surge in gas prices or slide in sterling versus the dollar. In effect, the UK’s public sector finances were intricately linked to the outcome of the Russia-Ukraine war. Putin’s reaction to defeats on battlefield could lead to further restrictions on Russian energy exports, resulting in a surge in the amount of debt issued by the UK government to offset energy bills.
There were deeper seated problems which limited Kwarteng’s time in office and turned Truss into a lame duck Prime Minister. For several years the UK’s institutional structure has been hollowed out. MP Michael Gove’s infamous remark during the Brexit campaign that “I think the people of this country have had enough of experts” is a prime example of politicians offering simple solutions to complicated problems. Kwarteng’s fiscal statement proceeded without the normal procedures of an economic forecast from the independent Office of Budget Responsibility. October saw an unpleasant lack of co-ordination between the political elite and the policy making establishment. The Conservative government understandably wants to raise living standards for the population. Truss was desperate to boost economic growth. Conversely, the Bank of England wishes to lower the growth rate of the UK economy, indeed to raise unemployment so as to bear down on wage pressures and limit core inflation. Headline inflation is outside its control, indeed at a 40-year high, as food and energy prices react to international events, but the Bank is wary of deteriorating inflation expectations.
There are tensions too within the Bank of England. The Monetary Policy Committee is raising interest rates and desires higher borrowing costs in order to restrain demand. The Financial Policy Committee became very concerned about the impact of higher bond yields as these adversely affected the ability of defined benefit pension schemes to meet their short-term cash commitments. A liquidity rather than a solvency crisis caused considerable forced selling across gilts and equities as long-term pension schemes rushed to meet short-term funding problems.
A sorry state of affairs indeed for the incoming Prime Minister, Rishi Sunak. The new Chancellor, Jeremy Hunt, has reversed the majority (£32 billion) of the planned £45 billion of tax cuts, and in his forthcoming fiscal statement will announce a series of tax raising measures, probably on energy companies and banks, and cost savings, for example overseas aid, to bring public sector finances back into some semblance of order. Higher levels of inflation will help, in terms of VAT receipts, whilst fiscal drag from wage increases will also boost income tax receipts. More needs to be done; for debt to fall as a share of GDP, the government needs to find a further £30-40 billion a year by 2026/27, according to leaked reports from the OBR. The review into, and the eventual cost of, the energy price guarantee becomes particularly important.
The UK episode might be extreme, but many of the flaws and failings in this sad episode can be seen in other countries, too. In Germany, Olaf Scholz has announced a major package worth €300 billion to limit the pain on households from higher energy bills. Meanwhile, the ECB is steadily raising interest rates to slow an already slowly growing EU economy as it battles to restrain inflationary pressures from becoming embedded. In Italy, Giorgia Meloni, leader of the new far right government, came into office with grandiose plans for large tax cuts and expensive nationalisation projects. Market concerns mean the spread between benchmark Italian and German government bond yields has already widened towards 2.5%. In the USA, the outcomes of the approaching mid-term elections remain uncertain. If the Democrats unexpectedly retain control of both houses, then fiscal largesse would be highly likely in the run up to the 2024 Presidential election, complicating the work of the Federal Reserve to bring inflation under control. Political desires for lower unemployment and higher pay are directly at odds with the current needs of central banks.
A further problem relates to servicing the large amount of government debt built up since the Covid pandemic. Most advanced economies now have debt/GDP ratios around or above 100-125%. For years this was kept under control via the zero interest rate and quantitative easing policies enacted by central banks. UK debt servicing only cost 1-2% of GDP at its trough, now higher bonds yields mean it is on course for 3-4%. Where next for central banks? Proponents of fully fledged central bank independence would advocate a rapid shift towards quantitative tightening, to reduce the threat to balance sheets from capital losses. Conversely, if the outcome is disorderly financial markets, then more central banks might be forced to follow the example of the Bank of Japan and undertake continual yield curve control.
In terms of policy making, the world economy is moving from a lengthy period of tight fiscal and loose money towards loose fiscal and tight monetary. Classic economic analysis (the famous Mundell-Fleming IS/LM models) would suggest that such an outcome leads to a strong currency, as indeed has been the case for the US Dollar, the world’s sovereign currency, which recently reaching a 20-year trade-weighted high. Conversely, the depreciation of the yen, euro, and most other currencies has resulted in imported inflation, especially food and energy prices. Sterling did hold up versus the Euro whilst the Bank of England was more aggressive in its interest rate decisions than the ECB, but recent capital flight proved too great during the sell-off in gilts. After all, overseas investors hold about 30% of the gilts market. Mark Carney, the former Governor of the Bank of England, warned that funding the UK’s large current account deficit relied on ‘the kindness of strangers’. This has now been severely challenged, if not lost.
Policy errors happen for many reasons. As Prime Minister Harold Macmillan famously remarked the major problem is ‘events, dear boy, events’. However, events in the UK were brought about by a lack of diversity of views within the Conservative party, by a lack of checks and balances in the policy making process, by a focus on short-term issues at the expense of long-term planning. This is exactly what elements of other political parties, notably certain Republicans, wish to bring about. Lessons have been learned; Jeremy Hunt has appointed a new economic council to provide economic advice, and gone out of his way to demonstrate joined up thinking with the MPC and OBR. Such changes were necessary but of course they are not sufficient to stabilise the situation. The risk premium for investing in UK assets, exemplified by the much wider spread of gilt above German bund yields, could well endure some time.
Longer term, governments need to push ahead with a stream of difficult, complex, politically contentious supply side and public sector reforms. They need to incorporate more universal income aspects into the tax and benefits system. They must create targeted policies offering better protection for the poorest sections of society and improve health and social care in order to reduce the percentage of the population who have left the labour force due to long-term illness or caring commitments. They have to reduce carbon-based energy usage, encourage efficiency, and boost the take-up of cheaper renewable energy sources. They must reform and modernize education systems to meet the needs of business and society in the 21st century. All these are expensive.
Ultimately, governments are beholden to two different groups – the public via their representatives in parliament, and the financial markets. Sometimes those ‘constituents’ want different things. Today is one of those times. So long as quantitative easing (QE) was in place, the cracks could be papered over. But no longer—the bond vigilantes are back with a vengeance.