Whatever the legend may say, Napoleon never himself said that he wanted “lucky” generals. Nevertheless, he would, for the most part, have expected that they did some homework before going into battle. Kwasi Kwarteng’s failure to have taken the time to check on what was brewing in financial markets (in which, incidentally, he used to work) largely explains why he has just been forced to resign as Britain’s chancellor of the Exchequer (finance minister) after only 38 days. The only chancellor to have been in office for a shorter period, at least since 1900, was Iain Macleod (1970), but in his case death made it difficult to carry on.
Kwarteng’s basic idea was right. Labour’s Blair and Brown may have squandered much of the economic legacy left behind by the Thatcher and Major governments more slowly than expected, but squander it they did. More surprising was the failure of subsequent Conservative governments to return to the free-market principles that shaped the policies that did so much to turn around Britain’s economy after Thatcher’s election in 1979.
Tory governments have been moving (economically) leftward for years. The reasons for that shift — and the political calculations that help explain it — are beyond the scope of this post, but the shift is real enough. Thatcherite radicalism has been replaced by something that is not even traditional Toryism, but a soggy (sort of) Christian Democratic mush. The economic results have, predictably, been somewhere between mediocre and poor.
Liz Truss, Britain’s new prime minister, wants to return Conservative economic policies to something closer to the Thatcherite model. She appointed Kwarteng chancellor to help her do that. In his ill-fated “mini-budget,” Kwarteng set out plans both to lower income taxes and to make them somewhat less progressive. He also was going to cancel a planned increase in corporation taxes. In principle these were all changes for the better. The fact that Kwarteng wanted to push these changes through quickly shows that his heart was in the right place, his head, well . . .
He appeared unaware or unconcerned that, with interest rates rising globally, the bond vigilantes (international brigade) are finally stirring after their long slumber. The immediate market reaction was dramatic. The pound, which, like most currencies, has been weak against the dollar, plunged to a historic low against the greenback, but, more tellingly, slumped against the euro too, while yields on gilts (British government bonds) rose sharply. Thatcher understood the value of incrementalism (where necessary) and careful preparation. Kwarteng and Truss, not so much.
The era in which investors were generally prepared to shrug off high government indebtedness appears to be ending. Even if, by the debased standards of our times, Britain’s debt/GDP ratio of 84 percent is not excessive, Kwarteng should have taken the trouble to check out market sentiment more than he did, especially in light of the recent decision by the Truss government to spend billions on shielding households and business from the worst of what the energy market might now have in store. That decision may not have directly contributed to the sell-off, but to follow that spending with tax cuts undoubtedly did.
Making matters worse is that the slump in gilts was exacerbated by, to use a polite term, technical factors.
I wrote about this a few days ago here. An important part of the background is that Britain has a (relatively) high percentage of defined benefit pension schemes. In an era in which interest rates were running at ultra-low levels (and thus gilts yielding next to nothing), pension-fund managers with a high gilts exposure needed to do something to soup up their returns. They did this by turning to “liability-driven investment” (LDI), or, to put it another way, the use of derivatives. When a derivative trade starts to go sour, those on the hook have to post more collateral. In this case, the derivatives were interest-rate sensitive. When yields began to rise, so did collateral requirements, and when yields rose suddenly, as they did after Kwarteng’s mini-budget, so did the collateral requirement. In some cases that forced pension-fund managers to raise cash by dumping gilts. That, of course, pushed yields up still further, driving the price of gilts down yet more. A doom loop was beginning to turn.
There will be other financial debacles as the ultra-low-interest-rate era recedes into the past. And, for that matter, Kwarteng will not be the last politician to pay the price of our admission into an era of more realistically priced money. Moreover, as we have already seen in the bond and equities markets, that price will be paid not only by politicians. Other asset classes await their rendezvous with the chopping block.
The Bank of England stepped in to buy gilts. That stabilized markets (more or less), but this support ended today.
Whether Kwarteng should have known about the danger that LDI could pose is a matter of debate, but, whatever its cause, the meltdown sealed his fate. Financial crises feed on themselves. To have a chance of fending off a repeat, Kwarteng had to sound the retreat. The planned cut in the top tax rate was quickly abandoned, it became clear that politically toxic “austerity” was moving rapidly up the agenda, and it was obvious that Kwarteng’s intention to cancel the increase in corporation tax was in trouble (the cancellation was indeed canceled shortly after his resignation).
Battered gilts, a battered currency, and a Bank of England rescue (as well as the commentary that accompanied it) had left Kwarteng and Truss with a reputation for incompetence that was going to prove expensive economically and politically — and hard to shake. Truss clearly thought that her best chance of hanging onto her own job was to “persuade” Kwarteng to give up his. Whether either Truss or her effort to change the direction of Tory Party policy will survive remains to be seen. The appointment of Jeremy Hunt as Kwarteng’s successor suggests that the latter, at least, is doomed.