When Kwasi Kwarteng claimed his budget-busting plan for growth would usher in a “new era”, it is unlikely he had in mind a sterling crash, rocketing mortgage rates and a 33-point poll lead for Keir Starmer.
But over seven nerve-shredding days, Kwarteng and Liz Truss’s bold economic experiment, hailed with glee by the free market thinktanks, has been comprehensively trashed.
After Friday’s historic statement, Kwarteng was sufficiently relaxed to take his advisers to a Whitehall pub, posing for selfies with the landlady. By the end of this week, he was scrambling to find spending cuts to make his sums add up in the face of soaring borrowing costs, while telling reporters: “we are sticking to the growth plan”.
Kwarteng’s aides insist he remained consistently calm as his cherished plan was given a kicking by the markets. But as the Conservatives’ party conference kicks off in Birmingham this weekend, many of the chancellor’s colleagues are anything but relaxed.
Much of last Friday’s plan consisted of policies heavily trailed in Liz Truss’s leadership campaign. But the pair chose to throw in more costly and contentious measures, including scrapping the 45p top rate and uncapping bankers’ bonuses.
In total, it was the biggest tax-cutting package for 50 years, and came on top of the radical energy price guarantee: the emergency response to gas prices sent rocketing by Russia’s invasion of Ukraine, which Kwarteng and Truss had chosen to fund entirely through borrowing, and could cost up to £150bn.
Investors hoping to look under the bonnet of this “new era” were denied independent forecasts from the Office for Budget Responsibility (OBR), while Kwarteng made clear his disdain for “Treasury orthodoxy” – underlined by the sacking of its permanent secretary, Tom Scholar.
“Not having an OBR forecast was a very deliberate decision to say, we are not interested in these people who have this irritating insistence on having spreadsheets and numbers and things like that,” says the economist Jonathan Portes, of the thinktank UK in a Changing Europe. “They obviously had to do the energy price guarantee, or something very much like it. They did not have to do large unfunded tax cuts, and they certainly didn’t need to do large unfunded tax cuts for rich people.”
Monetary policy
The job of the Bank of England, which since 1997 has had the statutory task of hitting the inflation target set by the government – currently 2%.
Fiscal policy
The Treasury is responsible for fiscal policy, which involves taxation, public spending and the relationship between the two. 'Fiscal easing' is when plans for tax cuts not are not matched by planned spending cuts.
Budget deficit
The gap between what the government spends and its tax revenues
Government debt
The sum of annual budget deficits – and the less frequent surpluses – over time.
Government bonds
In the UK these are known as gilts, and are a way the state borrows to finance its spending. The fact that governments guarantee to pay investors back means they are traditionally seen as low risk. Bonds mature over different timescales, including one year, five years, 10 years and 30 years.
Bond yields and prices
Most bonds are issued at a fixed interest rate and the yield is the return on the capital invested. When the Bank of England cuts interest rates, the fixed return on gilts becomes more attractive and prices rise. However, when interest rates rise gilts become less attractive and prices fall. Therefore when bond prices fall, bond yields rise, and vice versa.
Short- and long-term interest rates
Short-term interest rates are set by the Bank of England’s MPC, which meets eight times a year. Long-term interest rates move up and down with fluctuations in gilt yields, with the most important the yield on 10-year gilts. Long-term interest rates affect the cost of fixed-rate mortgages, overdrafts and credit card borrowing.
Quantitative easing and quantitative tightening
When the Bank of England buys bonds it is called quantitative easing (QE), because the Bank pays for the bonds it is purchasing by creating electronic money, which it hopes will find its way into the financial system and the wider economy. Quantitative tightening (QT) has the opposite effect. It reduces the money supply through sales of assets.
Pension funds and the bond markets
Pension funds tend to be big holders of bonds because they provide a relatively risk-free way of guaranteeing payouts to retirees over many decades. Movements in bond prices tend to be relatively gradual, but pension funds still take out insurance – hedging policies – as protection to limit their exposure. A rapid drop in gilt prices can threaten to make these hedges ineffective.
Margin calls
Buying on margin is where an investor or institution buys an asset through a downpayment and borrows money to cover the rest of the cost. The upside of margin trading is that it allows big bets and higher returns when times are good. But investors have to provide collateral to cover losses when times are bad. In times of stress they are subject to margin calls, where they have to find additional collateral, often very quickly.
Doom loop
This is where a financial crisis starts to feed on itself, because institutions are forced into a fire sale of their assets to meet margin calls. If pension funds are selling gilts into a falling market, the result is lower gilt prices, higher gilt yields, bigger losses and further margin calls.
Fiscal dominance
This is where the Bank of England is prevented from taking the action it thinks is necessary to combat inflation because of the size of the budget deficit being run by the Treasury. Fiscal dominance could take two forms: the Bank might keep interest rates lower than they would otherwise be, in order to reduce the government’s interest payments on its borrowing, or it might involve covering government borrowing by buying more gilts.
Larry Elliott Economics editor
Even before the chancellor’s outing to the pub, the pound had taken a pummelling on foreign exchange markets, closing the day down five cents against the dollar, at $1.08, near historic lows.
Government bonds, known as gilts, had also seen a sell-off. And markets were predicting a sharp increase in interest rates, as the Bank of England stepped in to offset the inflationary impact of the plans.
Yet such was Kwarteng’s Etonian sangfroid in the face of market turbulence, when he appeared on the BBC’s Laura Kuenssberg show on Sunday morning, he suggested there was “more to come” on tax cuts.
By Sunday evening, the sterling sell-off had resumed in earnest on the Asian markets; and when the bond markets opened in London on Monday morning, it turned into a rout. Yields on 10-year bonds – the interest rate at which the government borrows – shot up above 4%, and continued to climb through Tuesday, hitting 5% – the highest level since the financial crisis of 2008. Bond yields climb when bond prices fall.
Such was the chaos that the Treasury and the Bank of England issued coordinated statements on Monday afternoon. Kwarteng promised to publish his fiscal plans on 23 November – earlier than planned – and the Bank said it would “ not hesitate to change interest rates by as much as needed”.
Whitehall sources suggest Truss and Kwarteng clashed over whether such a statement was necessary, with the prime minister keen to ride out the storm. No 10 denies that.
Meanwhile, it was rapidly becoming clear that the tremors in financial markets were being felt far beyond the City. By Tuesday, almost 300 mortgage deals had been taken off the market, as lenders reassessed the outlook for rates. Estate agents were reporting chains collapsing, as lenders and buyers pulled out.
“It’s scary,” said the housing analyst Neal Hudson, of the consultancy BuiltPlace, who had already been predicting a market slowdown as interest rates rose to tackle double-digit inflation.
“I think the events of the last few days really increase the probability of a worse-case scenario of significant housing market downturn,” he said, pointing to how threadbare household finances are. He suggested the number of transactions was likely to decline sharply in the coming months, as potential buyers can no longer stretch to afford the home they hoped for. Sellers unable to wait would be forced to drop their prices.
At the same time, the 100,000-plus mortgage holders whose fixed-rate deals come to an end each month are likely to see their repayments jump sharply. Compared with a shock on this scale, the stamp duty cut announced with fanfare by Kwarteng last week is, says Hudson, “pretty irrelevant”.
On Tuesday evening, the International Monetary Fund joined the chorus of condemnation of the Truss-Kwarteng experiment, warning it risked worsening inequality and bluntly urging it to “reevaluate the tax measures”.
Truss’s backers among rightwing commentators reacted with mounting fury to each fresh voice condemning her plans, with the Tory peer Lord Frost saying they were part of “the international hectoring classes” – a group in which he included the Economist, the Financial Times, the former Bank governor Mark Carney and – improbably – Gordon Brown.
As the gilt sell-off continued into Wednesday, the vicious increase in yields, which had already gone up sharply in recent months, was wreaking havoc for pension funds. Facing the risk that panic-selling of bonds would create a self-fulfilling “doom loop”, and with some funds warning they were effectively in danger of becoming insolvent, the Bank rode to the rescue.
Threadneedle Street announced it would step in to buy gilts, and promised to continue doing so for up to a fortnight, to the tune of up to £65bn – an extraordinary volte face from an institution that until last week was hoping to be selling down its stock of bonds in a process known as “quantitative tightening”.
The Bank’s action did indeed put a floor under the gilts market; but also emphasised the seriousness of the situation. Kwarteng and Truss, meanwhile, were nowhere to be seen, hiding behind the convention that Labour is given a clear run during its conference week.
The prime minister finally emerged from her self-imposed purdah on Thursday morning with a series of interviews with BBC local radio – the traditional warmup for Tory conference. Grilled about the market chaos, she tried to focus on the generosity of the energy bailout, but appeared to flounder when challenged about the housing market, repeatedly pausing before replying. Mortgage rates were, she suggested, a matter for the Bank.
Labour’s deputy leader, Angela Rayner, joked that Truss had “finally broken her long painful silence with a series of short painful silences”.
With the moves in gilt yields alone adding £18bn a year to the government’s interest bill, according to calculations by the Resolution Foundation, pressure was mounting on Kwarteng to identify spending cuts to make his plans add up.
Asked whether he would honour Rishi Sunak’s promise that benefits for some of the poorest people in society would be uprated in line with inflation next spring, he said it was “premature for me to come to a decision on that”.
The public already appears to have come to its own decision about Truss and Kwarteng’s plans, however. A clutch of damning polls published on Thursday evening all showed Labour dramatically extending its lead – with the 33-point margin identified by YouGov pointing to an electoral wipeout for the Tories.
By Friday morning, Truss’s avowed dislike of “abacus economics” – as she described her leadership rival Sunak’s approach – had apparently been forgotten, as she and Kwarteng invited senior figures from the OBR into No 10 for a cosy chat.
Some semblance of calm had returned to the City at the end of the week, with the battered pound recovering some of its value. But as Tory conference opens this weekend, many of their colleagues fear Kwarteng and Truss’s “new era” will be one in which their own party is swept ignominiously out of power.
