The near collapse of the UK financial system yesterday is one of the biggest economic stories of the year. It should be a hard lesson for politicians the world over about economic policymaking and the importance of independent central banks.
Liz Truss and Kwasi Kwarteng’s disastrous, debt-fueled £45 billion tax cuts package didn’t just send the pound plummeting — it also started an interest rate surge that sent every major UK financial institution to the verge of halting lending, which would have plunged the real-world UK economy into a major 2008-style crisis.
Only the intervention of the Bank of England (BOE) prevented that.
The government’s tax cut package sent British government bonds — gilts — soaring, panicking holders of longer-term bonds, and sent short-term UK interest rates past 5%. That promptly froze the UK home loan market and threatened to do the same to business lending.
In a statement on Wednesday morning as market trading opened, the Bank of England warned the crisis posed a “material risk to UK financial stability” and suspended its program to sell gilts bought in its support program during the pandemic. Instead, it announced that it would spend £5 billion pounds a day to buy long-dated (mostly 10-year) bonds over the next 13 days.
That staved off a growing liquidity crisis and saved bondholders facing margin calls on long-dated bonds. It had the added benefit of supporting the pound without putting up interest rates. The BOE had earlier tried to calm markets, unsuccessfully, with statements of its intent to control inflation.
At the heart of this is an unfunded package of tax cuts for high-income earners, revealed in a statement that Truss and Kwarteng refused to call a budget because that would have required independent forecasts of the impact of the cuts and other massive spending changes proposed.
The package is a triumph of US-style Laffer Curve idiotnomics, premised on the idea that cutting taxes for the rich will spur enough economic growth that overall tax revenue will make up for the cuts. It’s Truss and Kwarteng’s one big idea, one deeply appealing to the wealthy Tory Party members in provincial England who voted for Truss. As a number of critics have noted, you can only do this sort of thing in the United States, where the US dollar’s status as a global reserve makes it highly resistant to fiscal recklessness.
It’s also deeply dangerous to do it when inflation is hovering at 10% and the central bank is pumping up interest rates to get inflation down.
Even Boris Johnson, a man devoid of ideas and entirely uninterested in doing the hard work of leading his country, never caused a panic like Truss, who has been distancing herself from the Bank of England with the hope of blaming it if her package fails ahead of the next election due in 2024. Now it’s the Bank that has saved the UK economy from her recklessness.
Ironically, UK Treasury said it would fully indemnify the BOE operations, despite the cause of the crisis originating in the package Treasury put together for Kwarteng.
Following the intervention, the pound steadied and rose from less than $US1.06 to $UD1.088 at 7am Sydney time, and markets calmed down.
The crisis illustrates a key point seemingly forgotten by all those lining up to have a crack at the Reserve Bank here, as well as central bank critics around the world. Independent central banks are trusted far more than politicians and are the adults in the room that markets look to when politicians cause chaos — and it is their independence that supports that trust.
While Australia’s economy is far stronger than that of the UK’s, and our government is in a much better fiscal position than Truss and Kwarteng’s, we shouldn’t forget we’re handing ourselves a massive unfunded tax cut in 2024, mainly to high-income earners, at a time when the budget remains deep in deficit. The government, and Treasurer Jim Chalmers, have plenty of credibility with markets currently. The UK disaster is a demonstration of what happens when untrusted politicians with no credibility do stupid things.
Meanwhile, Truss’ rival in the contest for the prime ministership, former chancellor Rishi Sunak, sits on the backbench, safely distanced from the chaos. Not to mention a certain recently ousted former prime minister.
