Kwarteng’s tax retreat—market minefield blows up the Tories

The Bank of England

Strangely enough, it has been Tory governments that have recently been the victims of brutal demonstrations of the power of global financial markets.

On Black Wednesday, 16 September 1992, the pound sterling was forced out of the European Exchange Rate Mechanism. This humiliation broke the back of John Major’s government.

Almost exactly 30 years later, on Monday 26 September 2022, the financial markets nearly drove the pound down to parity with the US dollar. A week later Liz Truss and her chancellor of the exchequer Kwasi Kwarteng abandoned the planned abolition of the 45 percent income tax rate to avoid it being defeated in the House of Commons by rebel Tory MPs. We have another broken-back government.

What does this crisis—which is very far from over—tell us about British and world capitalism? Truss’s and Kwarteng’s ineptitude is part of the story. Nicholas Macpherson, ex-permanent secretary to the Treasury, observed that “the chancellor had broken the cardinal rule at times of market stress—which is not to allow the UK to appear an outlier compared with countries of a similar size…the speed, style and scale of the ‘mini’ Budget took the markets by surprise.”

But in many ways the key lies in those words “market stress”. The global financial system is undergoing a major upheaval.

We can see this at two levels. The US Federal Reserve Board has reacted to the sharp acceleration in the rate of inflation over the past year or so by forcing up interest rates. Moreover, the Fed’s leaders said they will carry on doing this to until, they hope, unemployment in the United States rises sufficiently to force down the rate of inflation.

The effect has been to reinforce the dollar’s rise against other currencies. This tends to happen anyway at moments of great geopolitical and economic turbulence like the present. The dollar has risen against the currencies of almost all the top G20 economies not just the pound.

This has forced other central banks also to push up interest rates. The Truss-Kwarteng gamble that cutting taxes for the rich would boost Britain’s growth rate made sterling a juicy target to bet against for the hedge funds Kwarteng partied with after announcing the tax cuts.

But the second dimension of this global instability is that, since the crisis of 2007-9, the financial markets have coasted along upwards, boosted by the vast amounts of cheap money the central banks pumped into them to keep the world economy afloat. Firms became addicted to debt in an environment based on very low interest rates that has now—temporarily at least—gone.

This is a recipe for unexpected trouble. A good example is provided by Liability-Driven Investment (LDI), which almost no one had heard of till Wednesday last week.

Its unravelling prompted the Bank of England to reverse its decision to stop buying gilts (British government bonds).

Pension funds invest heavily in gilts, and LDI involves them buying derivatives to insure themselves against changes in interest rates and gilt prices. Put simply, in the high-stress conditions that developed last week as investors dumped gilts, LDI actually made the situation worse.

The Bank had to come to the rescue to stop gilt prices falling. But this was potentially a global crisis that shook the two most important government bond markets—US Treasuries and German Bunds.

One top London banker said “it got close” to a moment like the collapse of Lehman Brothers, which sparked the financial crash in September 2008.

The Financial Times column Unhedged commented, “Hidden leverage [debt used to finance investment] of this sort grows, like black mould in a basement, during long placid periods in markets. Low interest rates also provide a humid environment for financial fungi to grow. More floorboards will be ripped up, and more mould will be found, before this policy tightening cycle ends.”

But black mould is too benign a metaphor. The profitable wheezes and scams of the cheap money era are more like unexploded mines hidden in the global financial system. Truss and Kwarteng just blundered into the first.