This Isn't About Truss or Rishi: Our Financial Chickens Are Coming Home to Roost

By Anonymous Banker

I have a friend whose economic and financial analysis is always interesting because it is apolitical. He is a former City economist with decades of experience. Unfortunately, like many people who have something genuinely valuable to add to the conversation, he prefers to protect his privacy in our turbulent political and cultural landscape. But I’ve always found his explanations and insights useful and I think you will as well. That’s why he’ll be contributing to my Substack from time to time as the Anonymous Banker.

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We all know the story: Liz Truss and her accomplice Kwasi Kwarteng ‘recklessly crashed the economy’, and now the grown-ups in the form of Rishi Sunak and Jeremy Hunt have been parachuted in to try to put out the flames. In her 44 days, Truss caused irreparable economic damage to an economy already hamstrung by the self-inflicted madness of Brexit. Her ideological, hard right budget produced a massive spike in debt, forced the Bank of England to jack up interest rates and unleashed the previously dormant forces of inflation.

Or so the media would have us believe.

Yes, the value of the Pound did crash and the Gilt market (the UK market for government-issued debt) did react very negatively to the budget announcement. These moves were large and serious. But do not believe the wild conspiracy theories that they were somehow engineered by opponents of Truss or Rishi’s hedge fund mates. These are huge markets and participants in them act ruthlessly and dispassionately in their own self-interest, not to do politicians a favour. The reaction we saw was global investors’ genuine immediate opinion of the medium-term future for the UK.

What the media in the UK have not explained is why the markets reacted the way they did. In particular, they have focused on City bonus rules and the cut in the 45% tax rate. Reading the UK press, you would be forgiven for believing that highly paid City boys and girls were overwhelmed with concern for their fellow citizens and balked at the idea that they should be given a 5% pay rise, as well as uncapped bonuses going forward. So worried were they about the prospect of getting even richer they reacted by trashing the Pound to send Truss a message. This is fiction.

So let’s look at the facts.

The day before Kwasi Kwarteng delivered his statement, the Pound stood at 1.1261 against the US Dollar. At the time of writing, it is trading around 1.157 - marginally stronger. In the meantime, the Pound did trade as low as 1.03 and fears of going below parity stalked the market.

Consider the Gilt market over the same time period. The yield (essentially the rate of interest the government must pay on its debt) on UK 10 year bonds stood at 3.495% the day before the budget. In the aftermath of the statement, bond yields spiked to 4.506%. This is a very large move in a major G7 bond market in a very short space of time and shows that investors demanded an extra 1% of interest in order to lend to UK plc for a period of 10 years. A large rise in yields means that prices for bonds fell. The market decided that the right to receive interest from the UK government was less attractive than it was before. The market was downrating our bonds as global investors felt the likelihood of not being paid back by the UK, though very low, was higher than it was the day before. The extra 1% of interest represents the increased compensation investors demanded to hold UK government debt, reflecting the perception that its risk had risen.

The bond market has essentially recovered. Yields now stand at 3.65%. This move, and the strengthening of Sterling, likely reflects global investors’ welcoming the fact that the new Prime Minister has a markets background (and has previously publicly acknowledged the very issues the market is concerned about) and Chancellor Hunt is seen as a safe pair of hands. Notably, yields went back over 4% last Friday as the rest of the world digested the possibility that a free spending Boris Johnson might be heading back into office.

The markets moved in the way they did in response to the mini Budget because of the blank cheque promise to pay people’s energy bills. This open-ended commitment is estimated to have put the UK taxpayer on the hook for potentially £150bn, which would have had to be borrowed in the international debt markets. Markets hate uncertainty – faced with this hidden, uncapped liability they reacted by demanding a higher risk premium for lending to the government. The cost of the scrapping of the 45% rate, by contrast, was thought to be around £2bn.

In an economy that has doubled its national debt since 2014, £2bn is a rounding error. It’s irrelevant. £150bn of unfunded liabilities in the context of a country already in debt to the tune of over £2 trillion is very relevant indeed. This is why the bond market puked, and the Pound got hammered in the crossfire. Not because global bankers have suddenly decided they’re not too keen on free markets, low taxation and libertarian economic thinking after all.

Aside from uncertainty and the fear of not being paid back over time, bond markets hate inflation with a passion. Why? Let’s say I lend you £1000 at 5% annual interest, with you agreeing to give me the principal (£1000) back in 10 years. Let’s also say you earn £100 a year in this simplistic example. Each year your pay goes up by inflation (I know this doesn’t happen for most of us – call Mick Lynch to help you negotiate). However, your debt to me remains fixed at £1000. So, each year the cost of that debt becomes a lower percentage of your salary (benefitting you); and for me the value of goods I can buy with the £1000 when I finally receive it, is reduced by inflation - £1000 buys you less in the future than it does today.

Governments quite like inflation as it reduces their debt burden over time. Lenders hate it. It’s a transfer of wealth from the lender to the government effectively.

We have had decades of low inflation and this has made central banks and governments complacent. However, the genie is out of the bottle now, with inflation running at 10%+ in most major economies. This is another reason why the UK bond market was nervous about underwriting another government borrowing spree – they need to see inflation tackled to feel comfortable lending at the rates they would have done in the past.

We are where we are not because of Trussenomics, but because of economic and political mismanagement going back decades. G7 obsession with blocking fossil fuel investment and other interventions in our energy markets for political ends have caused problems that would have reared their head without the actions of Putin. Successive governments sought to flex their green credentials in their 5 year terms, hoping that clean energy would be on stream by the time it was needed. They didn’t stop to ask what would we do if it wasn’t? This is not an argument about climate change or in favour of fossil fuels – it’s simply pointing out that we leapt out of the plane hoping the parachute would be ready before we hit the ground. Faced with contractions in supply, there is only one outcome – higher prices. We chose to restrict capacity and are now paying the price.

The cost of this strategy (pursued by Blair, Cameron, May and Johnson) landed on the desks of Truss and Kwarteng in the form of an energy market crisis in the wake of the invasion of Ukraine. They responded with the equivalent of furlough for energy, rather than face the political backlash of people having to choose between heating and eating (we know that this is already a reality for some in the UK which is disgraceful). The actions of Cameron, Clegg, Milliband and Davey that we’ve seen unearthed in recent media clips from back in the day are what have brought us to where we are.

Michael Lane 🏖️ @mlanetrain

This is some grim real life dramatic irony: Nick Clegg opposing nuclear power in 2010 because it would only come on-stream by 2021 or 2022.

Trussenomics is also not responsible for the high inflation we are experiencing across the globe. This is a consequence of shutting economies for 2 years, destroying supply chains and productive capacity, whilst our central banks printed money like crazy. If a certain widget is needed in our cars and fridges (e.g. semiconductors) and their supply has been restricted because factories have been shut, the stock of widgets that were produced will be in high demand by the market – in the absence of more supply coming on stream, the only flex in a capitalist system is a rise in prices for these goods. This is the market reacting the way it should – higher prices signalling high demand should lead to suppliers raising supply and bringing prices back into line.

There are few real iron laws in economics comparable to those in physics like gravity or motion. However, it is as sure as night follows day that restricting supply will lead to higher prices. Try getting Champions League Final or Beyonce tickets outside the arena on the night. Conversely, raising supply lowers prices as the good in question becomes less scarce. Why is the value of a graduate job low these days? Increased supply made graduates a commodity in the labour market, eroding the graduate premium (another example of well-meaning state intervention with negative consequences).

Our central banks have been engaged in what they call Quantitative Easing. This is a fancy term for printing money. Thus, they have raised the supply of money in the economy. Increased supply of money leads to a reduction in its value – it is less scarce, and hence its purchasing power (the amount of goods and services it can procure) falls. This is the definition of inflation.

So, we have supply shocks caused by the response to COVID. To put a plaster on the wound we printed money as the government paid people to stay at home. Flush with cash, they’re now trying to buy the limited goods on offer and as a result we have inflation.

Does all this sound like Truss’ fault in 44 days? The massive debt was in place, along with inflation before she took office. An unfunded energy policy was the final straw.

The media has also chosen not to fully explain what Hunt’s policies really amount to. It’s been reported as a reversal of the reckless budget. This is true in as much as key policies were ditched. However, what they haven’t made clear in my view is that the cap on our energy bills has now been removed – after April they are uncapped and the media is already reporting fears of potential £5k bills. The hole in the budget, estimated to be £60bn, will require either tax raises or budget cuts. Taxes are already high relative to history. This leaves budget cuts as an inevitability.

In cheer-leading the defenestration of Truss and Kwarteng, the media has laid the groundwork for austerity. And, as we all know, the sequel is always worse: Austerity 2.0 will hurt so much more as I’ll explain in my next piece.