Lessons from a moronic episode

Two years after the UK financial crisis that followed Liz Truss and Kwasi Kwarteng’s “mini” Budget is a good time to learn lessons. The episode is in the past.

Two prime ministers and two chancellors later, the UK is just about to have another Budget that will again raise borrowing plans. And markets are a little nervous. But first, a recap.

Potted history

Liz Truss started her campaign to become prime minister shortly after Boris Johnson resigned in early July 2022. She was overwhelmingly the favourite to win, and it was evident during the summer that her tax-cutting plans were likely to lead to a substantial worsening of the UK’s fiscal position.

Ahead of the “mini” Budget, Truss and Kwarteng sacked the head of the Treasury for being overly orthodox, ignored the Conservative-created fiscal watchdog, the Office for Budget Responsibility, and highlighted that they would rip up the existing fiscal rules without a replacement.

Then, the “mini” Budget itself on September 23 2022 caused UK government borrowing costs to spike and the pound to dive, falling to an all-time nominal low of $1.035 against the dollar in Asian trading on September 26.

Although increased interest rates made UK pension funds more solvent (their liabilities were discounted at a higher rate), most defined benefit funds had engaged in “liability-driven investment” strategies that led them to be highly levered and face liquidity shortfalls when rates rose sharply.

This provoked forced selling of the liquid assets they had to meet margin calls — government bonds — exacerbating the initial problem. There was a feedback loop with government bond yields rising, more forced selling and so on. The IMF amplified the sense of crisis on September 27 with a highly unusual statement criticising the UK authorities and the “mini” Budget, calling for everything to be unwound later in the autumn.

The Bank of England stepped in on September 28 to rescue the situation with purchases of government bonds. Embarrassingly, this came on the day the BoE had said it would start quantitative tightening, ie selling government bonds.

A period of relative calm came to an end in mid-October with more forced selling by pension funds, prompting even more BoE intervention. That was when governor Andrew Bailey warned the pension funds that they had three days to sort out their mess and gave them a deadline of October 14. Yields spiked again and the UK was in the doghouse at the IMF all week. The central bank bought index-linked bonds, but Bailey’s gamble to set a deadline ultimately paid off. The financial situation eased.

Politically, chancellor Kwarteng scuttled home from the IMF in a torrential thunderstorm following a party at the UK embassy. He told journalists, including me, he was going home to “socialise” his new fiscal plan with colleagues — only to be sacked on arrival in London. Truss departed a few days later on October 20, having reversed almost the whole “mini” Budget.

Financial market effects

There has been quite a bit of argument ever since on the causes and roots of the crisis, especially from friends of Truss, so it is worth plotting the relevant data, starting from the beginning of July 2022, when it became apparent she would become prime minister.

There is no doubt that the UK was an outlier during the period from the moment it became clear Truss would become prime minister in the summer, with government borrowing costs rising much faster than in the US, Germany, France or Italy. The twin peaks during the crisis are evident with the reversal coming after BoE intervention. The chart is indexed to 100 at the start of July. Click on the chart to see the level of government bond yields during the period. The UK went from having 30-year borrowing costs below the US in August to above those of Italy within two months.

One of the more notable interventions during the crisis came from Dario Perkins, managing director of global macro at TS Lombard, who coined the phrase “moron risk premium” for the trends in the chart above, coupled with the fall in the exchange rate, below. This, he tells me, demonstrated that foreign investors were “dumping UK assets”.

Forward expectations of UK interest rates also soared. This was mercifully brief and by October 17, market forward interest rates were actually pretty much spot on — something that didn’t last long.

He says it was what you would expect to see in an emerging economy and not the normal actions of a developed economy where expectations of higher interest rates tend to raise the exchange rate.

One interesting wrinkle on the moron premium is that it was not a UK risk premium, linked to raised expectations of default of the UK government. In a new paper, former BoE deputy governor Paul Tucker argues that the most obvious way a government would default is through inflation, and market inflation expectations did not spike in the episode — as you can see from the chart below. Instead it represented foreign purchasers of UK bonds (while domestic pension funds held index-linked bonds) thinking the UK was just a bit of a crazy place to park money for a period.

The chart shows the implied market inflation expectations over three, five, 10 and 30 years, representing the average inflation expected over those periods. There was a rise before Truss became prime minister in short-duration inflation expectations, which was eased by Truss’s energy price guarantee limiting rises in retail electricity and gas prices, but nothing when the crisis was at full heat in late September and early October. (There is a relevant question about why UK inflation expectations are so high in general, but that is for another newsletter.)

Just to complete the picture, the final chart puts the episode into the context, bringing government borrowing costs up to date. Notice that the UK again has seen the largest rise in 30-year yields since July 2022 and now again has the highest yields of these countries. That is not good news.

The better news is that the exchange rate has recovered and higher yields are associated again with rising sterling, as the chart above shows.

Who did it?

This year there has been something of a growth industry in papers and commentary accounting for the spike in yields. One BoE paper, based on differential holdings of UK bonds by pension funds, reckons that roughly half the spike in yields resulted from fiscal policy and half from forced selling by LDI funds. Another BoE paper, which analysed actual trades in gilts, attributed roughly two-thirds of the yield spike over a 16-day period to the LDI vicious circle and a third to fiscal policy.

Last week Sushil Wadhwani, a former BoE Monetary Policy Committee member, used much simpler rules of thumb, to estimate that fiscal policy accounted for “plausibly less than one-quarter” of the rise in yields since August 2022, with the rest caused by the Truss government’s attack on institutions, the LDI crisis and global movements in yields that we saw in the charts. Wadhwani’s heuristic approach (rules of thumb for non-economists) earned him a dressing down from my colleagues at Alphaville, who preferred the spurious precision of one of the BoE papers.

The truth is that, given plausible margins of error, almost everyone agrees on the key facts. Truss triggered the crisis by ignoring institutions, loosening fiscal policy and generally appearing a bit unsuited to the job of prime minister. Fiscal loosening was not the most important issue. The LDI doom loop did the rest. As Perkins told me: “Diluting institutions and behaving recklessly in the context of the biggest global bond sell-off in modern history was obviously a very silly thing to do.”

Good crisis, bad crisis

This is inevitably subjective, but it’s important to have a view on what went well and badly during the episode.

Good crisis

• Governor Bailey and the BoE’s firefighting abilities put out the flames with bold action and some big calls

• The UK political system quickly rectified its error in making Truss prime minister and got rid of her in 44 days. That was fast

Bad crisis

• Truss and Kwarteng, for obvious reasons

• The UK political system for allowing them to get their hands on the levers of power

• The UK pension and financial stability regulators, including the BoE, failed to spot the LDI dangers. Tucker notes that “stability policy was found wanting despite . . . the reforms to banking that followed 2008’s systemic collapse”

• In particular, the stress tests of pension funds from 2018 were not remotely realistic in severity and did not take account of potential feedback effects

• The IMF poured fuel on the crisis, which . . . is not the IMF’s job

• The Federal Reserve and Swiss National Bank saw no lessons for themselves from the UK about interest rate risk and the financial system. This came to bite them just six months later when Silicon Valley Bank and Credit Suisse failed

Lessons

Clearly, the main lesson is, “don’t take massive punts with government policy”. There are other deep regulatory lessons I would recommend from Tucker’s paper. Here are five more general lessons.

1. If pension providers or other non-banks have risks that are similar to banks, they need to be regulated as if they were banks

2. Central banks need to formalise their role as market makers of last resort. It worked. As Tucker says, “central banks should not deny they will do something that, in fact, they will do”.

3. With central banks providing a backstop, more needs to be done in advance about the moral hazard this brings. Big penalties for executives who operate financial companies needing bailouts is one option

4. Economic institutions matter. Mess with them at your peril. They provide constraints so the financial markets do not have to. This one is for you, Donald Trump

5. The read across from the “mini” Budget to Labour’s coming Budget exists, but should not be exaggerated. A bit more borrowing, suitably constrained by institutions and plausible forecasts, is unlikely to hole the UK ship again

What I’ve been reading and watching

A chart that matters

Ever wondered what companies say in aggregate in their earnings calls?

Well, recently they are still warning about inflation risks more vocally than central banks as this tally from my colleague and data whizz, Joel Suss, using data from NL Analytics, shows. If you’re in the UK, you would be right to say that British companies are still warning more about inflation than those in other G7 countries.