Tough times lie ahead: Truss may turn out to be just the first leader to be felled by them.
Bond vigilantes are back, and politicians might not be prepared for the consequences.
L iz Truss‘s term as U.K. prime minister was as eventful as it was brief. After her government announced a series of tax cuts and hugely expensive spending plans to tackle the energy crisis, market panic ensued, with interest rates on long-term U.K. government bonds (gilts) rising sharply, setting in motion a doom loop as pension funds that had attempted to boost the return on their holdings of gilts were forced to sell assets to meet margin calls.
Only an intervention by the Bank of England — which purchased at least £65 billion worth of government bonds — could damp down spiking interest rates, obviously at a high cost to savers, since all that new money was effectively created out of thin air.
Truss Planned Three Times More Spending Than Tax Cuts
While many tried to portray the turmoil in the markets as a reaction to the planned tax cuts, it should not be forgotten that energy-price relief promised by Truss and her chancellor of the exchequer Kwasi Kwarteng amounted to £150 billion, which is three times as much as the tax cuts they planned to implement. Those lower taxes, by the way, would only reduce the overall tax burden in the U.K. to 35 percent of GDP, which is still higher than the 33 percent level dating from when Tony Blair became prime minister.
Following the market turmoil and the political uproar that followed, Truss replaced Kwarteng with a new chancellor, Jeremy Hunt, who immediately scrapped just about all planned tax cuts, but also will be cutting spending to reduce energy bills. Moreover, Hunt has made it clear that the fiscal squeeze won’t end with that.
Reaganomics
Some pointed out that Truss’s original policies — cutting taxes and increasing spending, all financed by higher debt — are not so much like Margaret Thatcher’s, but rather like Ronald Reagan’s policies. That’s because Thatcher did cut spending, while her government decided to raise interest rates rather than cut them — the Bank of England was not yet independent to set monetary policy.
On RealClearMarkets, John Tamny recalls how similar the economic debate was in the 1970s:
Republican George H.W. Bush felt Ronald Reagan’s proposed tax cuts were inflationary, as did Reagan’s eventual opponent for the White House in Jimmy Carter. Voters disagreed, but then policy should never be made by counting heads. Reality should tell the tale, in which case the rising dollar in the 1980s ridiculed the notion too much economic freedom brought with it currency debasement.
Reagan was also very successful in stimulating the economy, with 92 months without recession from November 1982 to July 1990, one of the longest period of sustained peacetime growth in U.S. history.
For the U.K., however, it is important to keep in mind that one big difference with the U.S., as Harry Clynch puts it in The Critic:
America can — just about — get away with some of the questionable economics that Britain has unsuccessfully experimented with, because it has some major advantages that we don’t. Perhaps most significantly, America issues the world’s reserve currency. The US dollar is, by far, the most desirable currency in the world and dominates international trade. Investors want — and need — ready access to dollar-denominated assets. This was once true of the pound sterling, of course, in the long-gone days when Britain was the world’s foremost financial powerhouse.
Of course, the massive debt burden of the United States is a problem, but it is a problem that may remain chronic rather than acute, at least as long as the United States enjoys the “exorbitant privilege” (to quote the angry words of one French finance minister) of issuing the world’s reserve currency. The U.S. can print its own money and get away with it too, since the global economy runs on the dollar.
The Bond Vigilantes Are Back
In the end, Truss was sunk by the fact that, in an environment where inflation has now returned to the economies of the West, markets are once again acting as gatekeepers to keep debt accumulation in check. The “bond vigilantes,” investors who keep a close eye on governments’ fiscal policies when deciding to start buying or selling countries’ government bonds, are back.
If Rishi Sunak, Truss’s successor, wants to continue a true pro-growth policy of tax cuts, he must do what Thatcher did, which was to reduce the size of the state in Britain.
All government departments, except defense and health, have already been told to start finding savings, reportedly as much as 15 percent of their spending. Take a step back, however, and we see that U.K. government spending will still rise in the coming years, but by less than first planned.
In theory, the Bank of England will finally start “quantitative tightening,” or deleveraging its own balance sheet and cheap money policy November 1, although this will exclude the long-dated gilts that were at the center of the recent market storm.
Those who think such pressure from the markets is only for the U.K., and not for other debt-laden Western governments, err. The Dutch central bank already urged pension funds to take action to prevent a bond-market crisis like the one recently experienced in the U.K., and the European regulator also recently warned banks to limit leverage — lending to borrowers who are already in debt — with that regulator reportedly finding that they are being ignored.
The European Central Bank is currently going much further than the Bank of England to shore up the finances of shaky euro-zone countries such as Italy and Greece. As in the U.K., inflation in the euro zone is reaching record highs and as in the U.K., the central bank is dragging its feet to intervene sharply because the end of cheap money is so painful at high debt levels.
Tough times lie ahead: Truss may turn out to be just the first leader to be felled by them.