The events that have unfolded on UK's leadership transition and the bungled mini-budget over the last month or so is teachable in many respects.
It started with a leadership revolt ousting the dysfunctional administration of Boris Johnson. In the long-drawn leadership contest, Conservative Party members elected Liz Truss. The vote was premised on her opponent Rishi Sunak as being seen as too liberal and Truss being the true Conservative. She appointed Kwasi Kwarteng, with whom she had collaborated a decade earlier in writing a book extolling supply-side tax cuts to "Unchain Brittania". In late September, the duo announced their mini-budget which entailed several tax cuts without any clear expenditure reduction proposals. The measures were universally condemned as never before by economists including by the IMF. The markets reacted by driving down the pound, British gilts and stock market.
The duo first retreated by reversing the cut to marginal tax rate. This did not stop the revolt nor did the market pressure decrease, forcing Truss to sack Kwarteng, after 38 days in power, the shortest tenure in UK Treasury in two centuries. With Jeremy Hunt, a member regarded as belonging to the left-wing of the Conservative party taking over as the Chancellor, there is now the strong likelihood that the entire set of tax cuts look set to be reversed. Hunt has already indicated that the government went "too fast, too far" with the mini-budget. In fact, instead of just tax cuts, the Truss administration could end up enacting tax increases when he lays down the Budget later this month!
That would be an almighty U-turn, and make Truss's continuation almost untenable.
Some observations:
1. The importance of political management before governments take major decisions. In this case, pretty much the entire Conservative party has gone up in arms against the mini-budget. This gives the impression that the decisions were taken without any internal consultations by a duo who were bent on implementing their ideological agenda immediately after taking over. The revolt in the Party has been near total and now threatens to unseat Truss herself.
2. It's inconceivable that the mini-budget was not designed with the help of consultants and, more importantly, right-wing ideologues. The Institute of Economic Affairs has been identified as being involved. None of these consultants and ideologues (like this one) will ever be held accountable for the abject failure of their prescriptions on a market-test. They'll continue to peddle their ideologies. Academics, think-tanks, and consultants (experts in general) face no accountability for actual performance of their ideas.
3. The timing of the mini-budget could not have been worse. The British economy was already facing strong headwinds, inflation was running riot, and a recession was imminent. The British citizens were already struggling with astronomical increases in energy prices. The global economic prospects too were weak, perhaps positioned on a cliff edge. Geo-political uncertainties around Ukraine and China-US Cold War added to the problems. It's staggering that the duo thought that they could pull this off at this time.
4. The turmoil in the British gilt markets was another sobering reminder to governments everywhere about the extent of influence markets exercise over the economy. This "market restraint" on government policies means that governments of any ideological dispensation should think twice before taking important decisions. There should be a very strong basis for those which are radical breaks from status quo. Despite professions to the contrary by right-wing ideologues, markets are not ideological, but practical.
5. Every financial crisis has its trigger lurking in some dark corner of the financial markets. The trigger this time was an implosion among pension funds who had been using liability driven instruments (LDI) to hedge against declines in bond prices. In the UK, LDIs have quadrupled from £400 billion in 2011 to £1.6 trillion by 2021. Sample this,
Coming into 2022, the DB pension market had grown to £1.8 tn and LCP estimates that around 85 per cent of liabilities were hedged using LDI programs.
Since corporate balance sheets have to show pension liabilities on mark-to-market basis, pension funds are forced to constantly rebalance their portfolios. This, in turn, makes them rely on derivative instruments like LDIs as insurance-type contracts to match the shortfall between their assets (bonds etc) and liabilities (pension payouts). Pension funds have to post additional cash as collateral against their LDI derivatives when the underlying bond prices decline. Once the yields on gilts rose sharply, the margin calls for cash collaterals increased steeply. This left pension funds scrambling for cash to cover their positions.
But when UK bond yields rocketed in just a few trading sessions, it triggered emergency collateral calls for pension funds to cover their LDI-related derivatives in a matter of hours, as rising yields mean the value of bonds falls. Pension funds struggled to find the cash in such a short time, forcing some to sell gilts, thereby putting further downward pressure on the bond market... Other assets like property and corporate bonds are also being sold to raise cash, but these can be harder to sell in a hurry and some are being sold at hefty discounts... To manage the instability in markets, the Bank of England has pledged to buy gilts worth 65 billion pounds in a scheme designed to take pressure off the pension funds.
In the days ahead regulators will follow-up by mandating higher capital buffers for pension funds etc holding LDIs. But how much is adequate enough?
6. The squeeze felt in the bond markets is also a reflection of the deficiency of deep enough market makers. The regulatory changes after the financial crisis had forced banks to retreat from market making operations, leaving investment banks and other financial intermediaries to perform this role. And they have repeatedly found inadequate in such market making role.
7. The turmoil should also have been predictable. After all, for several years now, central bank purchases of bonds had kept yields at ultra-low levels. It was only to be expected that a roll-back of the purchases, howsoever calibrated, should have its knock-on effects on market sentiments. Given the excessive extremes to which bond prices had strayed, the reversal is generating a symmetrically excessive recalibration to the other extreme. The much dreaded duration risks are now surfacing.
8. A less discussed aspect of the whole episode has been the quiet firmness of the Governor of Bank of England, Andrew Bailey. While the BoE was forced to intervene with a bond-buying program to backstop the bond market crash, it sought to limit any moral hazard by insisting that it's only for a very short period. Bailey refused to extend the bond-buying, thereby sealing Kwarteng's fate. Score one for institutional autonomy and quiet firmness (the test of which is that it does not get widely discussed).
9. Bailey's task was cut out - prevent moral hazard while limiting market instability. The closure of bond-buying program forced pension funds to reduce their derivatives exposure. An alternative liquidity facility was created to take the place of the bond-buying program so as to backstop the markets in a less direct manner. It'll be remarkable if the UK assets are becalmed by this tight-rope walking. Talking about doing just about enough?
10. The right-wing may have done Britain a favour with this fiasco. It has perhaps nipped in the bud any nascent signs of a return to supply-side economics. Politically too, even though there's time, the scale of the disaster may have sealed the Conservative Party's reign on power in the next elections. Conservatives are now nearly 30 points below Labour in opinion polls.
11. Finally, the leadership vacuum in UK is stunning. As FT wrote recently, since David Cameron, the UK's leadership roll call - Theresa May, Boris Johnson, and Liz Truss - look less than ordinary and resembles Italy's rotating cast of leaders. The cupboard looks barren.
Update 1 (22.10.2022)
The lettuce did last longer, as Truss resigned after 44 days in power, the shortest tenure by a British PM. FT summarised it well,
Truss had subjected Britain to a high-borrowing, tax-cutting, libertarian experiment which fell apart on its first contact with reality. The markets recoiled, Tory poll ratings collapsed and her government imploded.
The Truss regime took the right-wing project to its extremes,
Right from the start, Truss had a fragile political base. Although she did not win the support of a majority of Tory MPs in the leadership contest, she immediately introduced a range of radical policies, which had been years in development by rightwing think-tanks and propounded by Tory supporting newspapers, but which had not been endorsed by the electorate. It was the culmination of the Brexit project supported by many on the right, which linked notions of “sovereignty” with the idea that once freed from the EU — viewed on the right as a supranational, regulatory monster — Britain could chart a route to a future as a small state, low tax, lightly regulated economy... former prime minister Boris Johnson had... picked fights with many of the country’s institutions: the BBC, the judiciary, even parliament itself were judged to be standing in the way. Truss went further, attacking the British economic institutions that serve as a guardrail against reckless policymaking and to maintain market confidence: the Bank of England, the Treasury and the independent Office for Budget Responsibility... Truss set about cutting taxes on the wealthy... Regulations, like EU directives that protected wildlife habitats from development, were to be repealed in “investment zones”. Developers would be freed from stipulations that they should include affordable homes in their plans. An EU cap on bankers’ bonuses was scrapped. Fracking for shale gas would resume.
It did not realise that neither the markets nor the Conservative Party itself was ready for this degree of free-market,
Truss said she was ready to be “unpopular” but had not anticipated that her programme would make her that unpopular. Conservation groups vowed “direct action”, the markets took fright at Truss’s massive borrowing plans and started a fire sale of UK gilts, and the prime minister’s approval ratings plummeted to record lows. Even Truss started to recognise the limits of the government’s approach. When Jacob Rees-Mogg, the Brexit-supporting business secretary, proposed a bonfire of EU workplace rights, an ally of Truss described the ideas as “half-baked and unworkable”. City of London regulators pushed back against her drive to water down EU financial rules.
And the regime may have done enough damage to put back the right-wing experiment by several years or even decades,
One Tory MP said simply: “She has ruined it for the Brexit project and free marketeers for a generation.”... her new chancellor, Jeremy Hunt, ripped up most of the unfunded tax cuts. A new era of fiscal conservatism, embedding the right’s hated “Treasury orthodoxy”, has been decreed by the markets and whoever becomes the next prime minister is likely to pay obeisance to them.
Also this from Timothy Garton Ash in the Times,
“The Conservatives are never going to recover the coherence that will make for good governance,” said Timothy Garton Ash, a professor of European studies at Oxford University. “This is a party that is tearing itself apart.” He traced the party’s unraveling from the 2016 referendum, called by Mr. Cameron, through Mrs. May’s futile efforts to craft a softer form of Brexit, to the uncompromising “hard Brexit” of Mr. Johnson, and finally to Ms. Truss’s experiment in trickle-down economics, which he said bore all of the hallmarks of Brexit thinking, from the derision of expert opinion to the disregard of Britain’s neighbors and the market. “It’s taking the logic of Brexit to the absurd,” said Professor Garton Ash, who has long lamented the vote to leave.
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