Boris Johnson promised us that we could have our cake and eat it. So we ate the cake. When his successor, Liz Truss, went to the cupboard to look for it, she found that it was all gone. The transition from the bounty of tax cuts and energy subsidies promised by Ms Truss when she took charge to the austerity being promised just a few weeks later is one the most dramatic policy reversals I have ever seen in Britain.
During her selection campaign for the leadership of the Conservative Party, Ms Truss railed against “Treasury orthodoxy”. This, she said, was responsible for the country’s strangled growth since the financial crash of 2007-09. She knew what she was talking about since she had served as Chief Secretary at the Treasury for a stint in 2017-19. This was a widespread complaint. I heard it made by Lib Dems during the coalition years, especially as many ideas for long-term investment were shut down. The complaint was much more virulent from Labour supporters, for whom “Austerity” was the root of all evil. It is interesting to see these usual suspects being joined by the libertarian right, who have elevated high tax levels to the same heights of evil that the left has for austerity.
It is important to distinguish Treasury orthodoxy from economic orthodoxy – though most people seem to do just this. Treasury types are steeped in economic orthodoxy: you won’t get away with the “lump of labour fallacy” (the idea immigrants, for example, take away people’s jobs) if you talk to one of them. But it is tempered by an older belief, dating back to Gladstone and beyond, in “sound money”. They do not like to see high levels of government borrowing, leading to creditors being able to dictate policy. The divergence between Treasury and economic orthodoxy was especially evident in the coalition government of 2010-15. Many orthodox economists argued that austerity policies were at best overdone, or at worst completely wrong-headed. They suggested that there was significant slack in the economy, and that policies that reduced demand were a self-inflicted wound (whether there was as much slack in the economy as they thought, and whether the austerity policies were as destructive, are questions for economic historians). They produced as evidence more generous US policies at the time, leading to less economic hardship. The Treasury thought otherwise. In 2010 coalition ministers were scared witless by warnings of dire consequences in financial markets if austerity programmes weren’t followed. Both Tory and Lib Dem ministers accepted this basic premise, while quibbling with the details. The previous Labour government under Gordon Brown and Alistair Darling had as well. Almost all serious economic commentators now suggest that this was a serious mistake – and that the market position was not nearly as precarious as suggested.
Doubtless this is what gave Ms Truss the courage to take on the Treasury, though her central idea that tax cuts can be paid for through the growth they stimulate, especially when unemployment is at a record low and inflation on the rise, was a challenge to economic orthodoxy as well. She noted the substantial “headroom” in forecasts by the Office for Budget Responsibility (OBR) earlier in the year – doubtless brought about by stealth tax rises through holding tax thresholds down. She also noted that government debt levels were not as high as other some other big developed economies. So she appointed her close ally Kwasi Kwateng as Chancellor of the Exchequer, and his first act was to sack the leading Treasury civil servant, with talk of replacing him with an outsider.
It fell apart with startling speed. In the popular telling the “Markets” struck back, causing mortgage rates to shoot up. This has wiped out any feelgood factor brought about by tax cuts and energy interventions amongst a key constituency of Conservative voters. The talk about the power of Markets is a convenient shorthand, but oversimplifies things a lot. Media coverage as been very muddled. At first a lot of attention was focused on the pound – which at one point nearly sank to parity with the US dollar. But it was the gilt (government debt) markets that caused the mortgage rate problems. I think this took a lot of people by surprise, including, perhaps, our political leaders. In the common understanding interest rates are determined by the Bank of England, which was not due to meet until early November – so people probably expected any crisis on the mortgage front to approach slowly. In fact Bank of England decisions are only one factor amongst many – and mortgage providers need to look forwards at potential future rises. Then a crisis blew up with the liability matching policies in certain pension funds. I have read two tellings of this crisis. In one the pension funds had been indulging in reckless speculation camouflaged as prudent management of future cash flows; in the other prudent management was caught short by a temporary liquidity crisis dictated by the way certain financial markets are structured. The Bank of England rode to the rescue, but a temporary tiding over of a technical crisis was presented by many as something much broader. The Bank’s attempts to communicate what it was doing and why didn’t really help. Neither did Mr Kwateng’s attempts to shrug the whole thing off.
The muddle made things worse. The pound recovered, but gilt markets have not made life for mortgage providers any easier. But what has now been revealed to the world is what the point of Treasury orthodoxy is. Financial markets are complicated things, and they can affect the public in a number of ways. As with any market, they are the meeting place of people with many different agendas. If mismatches occur they can be destabilised quite easily. The Treasury tries to manage things by making orderly, predictable demands, and not pushing its luck. It builds up a reservoir of confidence which means that it can respond to emergencies. The timing of Ms Truss’s attempted coup could hardly have been worse. Rising inflation, low unemployment (showing limited capacity to expand the economy) and the energy crisis, coming after the trauma of the pandemic and alongside the destabilising effects of the Ukraine war, all pointed to this being a particularly delicate moment. Ms Truss’s attempt to blame the demise of her strategy on the markets is a bit like the Captain of the Titanic blaming the iceberg for the loss of his ship. Except that this was no stray iceberg, the government was steaming full-steam ahead the middle of a known iceberg belt.
Now the government, having destabilised things, is having to work very hard to restore order. Treasury orthodoxy reigns triumphant. The new chief civil servant is an experienced insider; an experienced senior politician has replaced Mr Kwateng as Chancellor; most of the tax cuts have been withdrawn; public spending cuts are back on the agenda; the energy price intervention has been scaled back. There was even talk of not raising the level of the state pension in line with inflation – the Treasury has long hated the so-called “triple lock” on pensions.
The dust hasn’t settled, but the effect of this change is chilling. It isn’t just tax cuts that have been put on ice – but hopes by politicians on the left of raising spending on public services and benefits now look much harder to fulfil. Suddenly Britain looks like a lonely nation living beyond its means in a hostile world. Hard choices lie ahead.
The comments I made on your previous posting are equally relevant to this one too.
” it was the gilt (government debt) markets that caused the mortgage rate problems.”
If there is a market in gilts it can’t be a free market given that the BoE is a significant player. Though, strictly speaking, the BoE doesn’t purchase Gilts. Their “Asset Purchase Facility” buys them using an interest free loan from the BoE but it all amounts to the same thing.
The problem for the BoE is that the Americans are pursuing an aggressive monetary policy of pushing up rates so the BoE has to follow to at least some extent, but not so closely that the viability if the financial system is compromised by falling bond prices. It’s a narrow path to follow. A tightrope might be a better analogy.
This doesn’t change the fact, though, that interest rates, both short and long term are effectively under Government/BoE control.
Interest rates are rising at the moment because the BoE wants or needs them to. It’s not the result of some market force except indirectly via the forex markets. The Government cannot control the pound’s value except marginally and temporarily. That was a lesson learned the hard way on Black Wednesday in 1992.
All previous crashes, including the Wall Street crash of 1929, have come about after Governments have raised interest rates too quickly or have allowed interest rates to rise too quickly. The Americans are the guilty party this time, and not for the first time. We can expect the crash, when it inevitably comes, to originate in the USA just as the 2008 crash did. I expect it will be even worse than then because the level of private debt is so much higher.
The Bank controls one interest rate directly -the short-term rate it charges to banks on reserves. Admittedly this pays a pivotal role in the whole system. It does not directly affect the price the Treasury has to pay on gilts. That DOES depend on a market – hardly a perfect one, and one in which the Bank may or may not be a player. Of course the price that investors are prepared to pay depends quite a bit on their view of the direction of the Bank’s interest rates. They are not taking a view on credit risk. But there are other factors. The principal alternative is a bank deposit, and since bank deposits are not generally available, that does depend on credit risk (even if subject to a deposit guarantee – you don’t want to get caught up in claiming it). There are also technical factors, particularly applicable to pension funds (liability matching, etc.) which put premium on particular maturities and index-linking. These factors usually work in the Treasury’s favour, though the maturity factor turned vicious after the budget. But uncertainty, another factor, doesn’t. If you think rates are going to rise, you might decide to keep your cash in the bank, and not participate in the gilts auction, forcing the rate upwards. I think that explains a lot of what is happening at the moment (though of course, the price is mainly set by investors dealing with each other on the secondary market, not with the Treasury, but the same logic applies). Another factor is the currency markets, as you point out – and the Fed is causing a headache here.
But there is something else – the bank is charged to control inflation. Of course a sinking pound is part of it – but they may also act to curb economic demand if they think there is a wage-price spiral going on – and there is some evidence for that. I think that was a big disconnect between Truss and the Bank. She wanted growth – the Bank saw it as its job to curb growth to tame inflation. So the harder she tried to stimulate, the harder the bank felt obliged to pour cold water on proceedings. Of course it might well have been better for to it the other way round (as I think you have suggested) – for the government to tighten fiscal policy to curb the wage-price spiral, while the bank kept interest rates down to promote investment. But Truss couldn’t see that.
I’m not sure that the Fed is wrong to jack up rates, given the inflation picture in the US and that a lot of the fiscal stimulus is still feeding through. But I do agree the consequences are potentially scary. But I also think that persistent very low interest rates are a bad thing in themselves, leading to an inefficient use of capital. They don’t seem to have done much to promote actual, productive investment, just endless leveraged speculation.
Finally we shouldn’t forget that mortgage rates, and other free market rates, have a strong credit risk component. Some people say that during the crash money was loose because the central banks cut their rates rapidly. In fact money was very scarce and the rates the public had to pay on mortgages and overdrafts went through the roof. If the banks foresee credit conditions getting worse, they will put up rates, regardless of what the Bank does.