Even allowing for the usual hyperbole and the media bias toward the dramatic, it is hard to disagree with the judgement that nothing in UK politics has resembled the last few days. A democratically elected party leader and prime minister deposed after 44 days. Her new Chancellor and Home Secretary already sacked. The entire economic strategy on which she was elected reversed. Without wishing to be conspiratorial, this certainly has aspects of a coup. But how, in the UK democracy could such a coup be arranged?
The obvious candidates are the financial markets and in particular the bond markets. The power of these markets has been in abeyance for decades but older hands remember the President Clinton advisor, James Carville saying, ‘I want to come back as the bond market. You can intimidate everyone’. If the bond market can intimidate the US government, the UK is surely easy meat.
On the surface the story is relatively clear. A new and radical right-wing Tory administration took power on September 6th with a ‘growth plan’ focused on tax cuts to accelerate the sclerotic growth of the UK economy. The main tax cuts had been heavily trailed in the long leadership contest without any noticeable financial meltdown. Three weeks later on September 23rd the new Chancellor, Kwasi Kwarteng, launched a financial statement, quickly dubbed a ‘mini-budget’. This included the already trailed tax reductions most of which were in fact merely decisions to hold existing rates for corporation tax and national insurance rather than to raise them as intended by the preceding Chancellor. Sunak’s planned reduction in the basic rate of income tax was also to be brought forward one year to 2023 and the top rate of income tax was to be reduced from 45% to 40%. Alongside the tax changes were a series of relatively small supply-side measures again intended to accelerate growth.
Rather than being welcomed as a sincere attempt to stimulate growth, the package was met by a storm of opposition. The IMF denounced it as impractical, and criticised it for increasing inequality even though that should not have been the IMF’s concern. The financially largest aspect of the package, a potentially huge subsidy to the energy industry to put a cap on electricity and gas prices, in the face of surging global fuel costs, was largely ignored even though was of particular help to low-income households.
The financial markets appeared to react to what they anticipated would be a significant increase in government borrowing. The main borrowing, for the fuel subsidy, attracted little concern. It was large but temporary and resembled the borrowing undertaken during the Covid pandemic. Financial markets had hardly reacted at all to the huge financial deficits incurred during the pandemic. Interest rates had not risen because the Bank of England, like other central banks, had bought back most of the additional government debt and hence funded the deficits by creating new money through their Quantitative Easing schemes. The fuel subsidies could not be dealt with in this way because serious inflation had reappeared and central banks were intent on raising interest rates rather than holding them down. Even so, the financial markets did not panic over this borrowing. Most other countries were doing the same. It was accepted.
It was the unfunded tax reductions that spooked the markets. The Chancellor appeared unconcerned about the funding of the tax changes, relying instead on a belief that lower taxes would stimulate sufficient extra growth to generate the required tax revenues. The key weakness was that virtually no-one in the economics or investment professions (including myself) believed this. For all of these people the implication was clear. The Chancellor’s sacking of the Treasury Permanent Secretary and refusal to allow the OBR to cost his plans, reinforced the view that he cared little about the extra borrowing. In fact, he boasted of further tax cuts to come.
Lower taxes meant higher borrowing. With the government about to flood the market with new bonds to fund their deficit, at a time of high inflation, investors demanded lower prices to buy UK government bonds.
A note on bonds is needed here. Bonds are issued with a fixed return, or coupon. A £100 bond might for instance promise a fixed £5 a year for its fixed lifetime. If the bond can be obtained more cheaply, say at £90 then the interest rate (i.e. £5 divided by £90 =5.6%) is higher. As soon as the mini-budget appeared, bond prices fell and interest rates on bonds rose.
Because household mortgage interest rates are tied to long-term bond rates, the cost of mortgages rose, although not immediately for those on fixed mortgage deals. Because many UK bonds are bought abroad the reduction in demand led the value of Sterling to fall. The pound had been worth close to 1.4 dollars at the start of this year quickly fell to a short-lived 1.03. Ten-year bond interest rates, which had been 3.1% a few days earlier, rose to 4.5%, implying a large future rise in mortgage costs.
Source. Bank of England. Note first vertical line is the date of the mini-budget. The second is Kwarteng’s resignation.
What Really Happened?
The accepted narrative is that these market reactions led first to the dismissal of the Chancellor on October 14th and a week later the resignation of the Prime Minister, but closer examination suggests that the market reaction to the mini-budget was not extreme and not large enough to account for the political consequences.
Let’s take interest rates first. The chart above (which extends to October 20th) shows that the 10-year bond rate came back quickly from its 4.5% peak to 4% and remained at that level following the sacking of Kwarteng on October 14th and the abandonment of the growth plan. The chart below shows that long-term interest rates were rising everywhere (as a consequence of high inflation). This
suggests that the rise in interest rates was not tied to the mini-budget or the growth plan. The table below for ten-year bond yields reinforces this view. Long-term UK bond rates on the day Liz Truss resigned were only around a third or half of one percent above their level prior to the mini-budget of September 23rd. By October 20th UK bond rates were still below those in the USA. More-over the rise in Euro-zone bond rates were larger over this month.
Ten-year bond rates are usually a little above the bank rate and, since the latter has been rising to contain global inflation, bond rates had also been increasing everywhere. Since the Bank of England is expected to raise the base rate from its current 2.25% to 3% or more in the near future, we can expect the bond rate to rise further. In other words, bond rates have been rising because of high inflation and while the mini-budget certainly caused a sudden spike in rates these would have risen anyway sooner or later. Nor is inflation much worse in the UK than elsewhere. It is below the OECD average and only a little above the USA (which has lower energy costs).
The same is true of exchange rates. As the media love to point out sterling fell to 1.03 against the dollar, but it soon recovered to 1.12-1.14. The decline of sterling is very largely due to the rise of the dollar against all currencies. The two charts below shows how the experience of sterling against the dollar closely mirrors that of the Euro. Against the Euro, the value of sterling shows only a small impact of the mini-budget and the current sterling-euro exchange rate is close to the average for the last six years.
So why the implosion?
If the financial consequences of the min-budget are not particularly extreme by the standards of recent years why has the Tory party and the media reacted with such ferocity? The reaction to the mini-budget was made more dramatic by problems in the pension funds. The funds themselves are strong and in no danger, but offshoots of several funds had borrowed money to buy further bonds in order to boost incomes in the recent periods of very low returns. These loans included ‘margin calls’ to put up more capital when the value of the bonds suddenly fell. Being short of ready cash the pension funds would have needed to sell bonds to raise cash leading to further falls in bond prices. In what sounded dramatic but was not, the Bank of England stepped in to buy bonds and shore up bond prices, thus preventing a meltdown. In 2008 the Banks were blamed for causing a crisis. In 2022 the pension funds escaped censure and the blame landed instead with the Government.
The key political factor has been the rise in mortgage rates, even though this will not be felt in most family budgets for a year or so. The evidence suggests that a substantial rise would have occurred anyway and that the mini-budget merely brought the rise forward. Mortgage rates are usually 1-2% above the Bank of England’s base rate although the gap has been nearer 3% over the last decade of low interest rates. If the base rate soon rises to 3% we could have expected mortgage rates of 4 – 5%. Since mortgage rates today are at around 5.5% the gap is not huge. US mortgage rates are already higher than this.
The problem for the Truss government was that the rise in mortgage rates was brought forward. It is unclear whether the mini-budget fiasco would have led rates to be permanently higher than they would otherwise have been.
Truss’s growth plan was deeply flawed but under normal conditions this might have taken several years to be proven. Kwarteng’s high-handed and insouciant launch of the plan, led bond dealers to assume he was about to flood the market with new bonds, making them reluctant to buy at the going rate.
Even then, the situation could have been managed. Kwarteng could have shown a little humility, admitted he under-estimated the new fragility of the bond markets, and quickly offered to delay at last some of the tax cuts until the consequences for borrowing could be estimated and managed. The shock of a falling pound could have been described as an over-reaction and the rising interest rates viewed as merely advancing a change which was coming anyway but which could be reversed as global inflation was reversed next year.
None of this was done and instead Kwarteng was sacked and the growth plan was suddenly abandoned by the new Chancellor, Jeremy Hunt, himself an odd choice as some-one without Treasury experience and a non-supporter of the growth plan. This was quickly followed by the dismissal of the new Home Secretary, Suella Braverman, superficially due to a minor security breach, but more probably because she strongly opposed the desire of Hunt to relax immigration controls in order to reverse labour shortages.
What was evident was that, alongside the jettisoning of the new Government’s core economic policy, two Brexiteers had been replaced by Remainers. The financial problems had been somehow linked by Remainers to Brexit – quite a stretch – and now Remainers controlled two of the three highest offices of state. This abject collapse by Truss was probably undertaken to give confidence to the financial markets but seems unnecessarily extreme. It remains unclear who exerted the pressure to move so far. Was it Tory financial backers, backbenchers or Tory grandees? The drama of the market reaction to the mini-budget certainly provided a good case that the Tories would lose the next election and perhaps several elections after that. The panic that set in ostensibly made things worse. We remain to see whether Truss’s replacement, probably Rishi Sunak, can reunite the party. He has form in his weakness over the Northern Ireland Protocol but if he firms up on the Protocol, manages spending cuts sensitively, and moves quickly to make levelling-up a reality, something may be salvaged.