Damien Grant: The UK is solving one crisis with another

Friday, 7 October 2022

British Chancellor Kwasi Kwarteng made an abrupt U-turn on his plans to scrap the top rate of income tax for the highest earners. Video first published October 4.

Damien Grant is an Auckland business owner and a regular opinion contributor for Stuff, writing from a libertarian perspective.

OPINION: I am not a financial wizard. Not even a financial muggle. The complexities of high-finance are as opaque to me as the Hogwarts Book of Personal Hygiene.

Thankfully, my ignorance has not prevented me from writing endlessly on matters economic, and the gyrations of the financial and monetary worlds have been a bountiful muse.

The recent near-death experience of the pension funds in England is a topic I cannot let pass, but before we unpack this drama, let’s enjoy a quick recap on how we got here.

* UK scraps tax cut for wealthy that sparked market turmoil

* British PM Liz Truss defends controversial tax cuts as UK remains on financial brink

New British prime minister Liz Truss and her chancellor, Kwasi Kwarteng, triggered an economic crisis with Kwarteng’s first mini-budget.

In the early 2000s, monetary policy in the Land of the Free-yet-heavily-financially-regulated was focused on generating low interest rates.

This led to a hunt for yield which resulted in lending generously classified at the time as sub-prime.

These loans would later be described more accurately as toxic, and the end result was the global financial crisis, when banks owing these assets had to admit they were worthless.

In response, the monetary and fiscal authorities faced a choice: allow the market to correct, with the necessary brutal recession, bankruptcies and loss of capital. Or do the other thing.

The market reaction to the British government’s economic plan was rapid and brutal.

They chose the other thing. Fifteen years of debt, money printing, and more than a decade of interest rates lower than the hem on a Carmelite nun.

Now, to be fair, this worked. The global economy avoided a depression and financial elites were spared the indignity of having to rub shoulders with those whose lives were turned over by their negligence.

However, there is no such thing as a free serving of foie gras, and the cost of this recklessness is becoming clear, thanks to the batty economic agenda of Liz Truss, the new British prime minister.

Truss outlined a plan to cut taxes, an admirable policy, while increasing the size of the state’s already bloated spending programme.

Critics would argue that Liz Truss has got Britain moving in the wrong direction and at speed.

To pay for this, her Chancellor, Kwasi Kwarteng, needed to borrow a lot of money. I understand the technical term for the amount to be raised is “a shed-full”. You won’t believe what happened next!

As this was occurring, the Governor of the Bank of England, Andrew Bailey, was in the process of raising interest rates and tightening money policy as inflation in the United Kingdom was running at 10%.

This is important to our story and I shall come back to it.

In response to this new fiscal environment, the market began downgrading the price of long-term UK sovereign debt. In essence, capital markets concluded that the UK government wasn't good for the money. The assumption being that default, through inflation, had become inevitable.

This had consequences. The main one was that many UK pension funds, which hold a lot of this debt, found themselves in trouble.

When the value of these long-term government bonds, commonly called gilts, fell, many pension funds become technically insolvent.

UK pension funds had been accumulating gilts. The interest on these bonds was used to pay the pensions of those who had diligently paid into the fund in past years, and that cash had been used to buy, amongst other things, UK government bonds.

Damien Grant may not even qualify as a financial muggle, but he knows an economic disaster when one is looming.

These positions had evolved in the pre-2008 years, when interest rates were higher than today. The pension funds still had open-ended obligations to pensioners, but the return on their capital was falling.

For reasons that is not obvious to me, as I am not a financial wizard, the response was to borrow cheap cash on the open market, buy more gilts and enjoy a small arbitrage in the interest rates.

However, if the value of the newly purchased bonds was to fall, the pension funds would become insolvent.

The chase for yield was driving irrational behaviour. Again.

To fight inflation, the Bank of England raised interest rates. This was good for monetary discipline, but it caused the value of bonds to fall. If I own a piece of paper with a nominal value of $1000 promising to pay 5% a year forever ($50), and the rate of interest rises to 6%, the value of my bond falls to $833 – 6% of 833 is $50.

This, combined with the lack of confidence the market had in the solvency of the UK treasury, caused the price of bonds to fall through the floor and into the dirt underneath.

At this point, pension funds faced calls on their capital. The most liquid asset at their disposal was gilts, which they couldn't off-load, and the industry wobbled towards insolvency.

The Bank of England faced a choice: allow a trillion-dollar financial sector to collapse, or maintain its credibility in the fight against inflation.

The Bank abandoned monetary discipline and used freshly created money to buy gilts.

The UK government is unable to finance its deficits with borrowed money and can only do so with printed cash. Truss, the most conservative Conservative in three decades, is unwilling or unable to reduce spending.

On this occasion, the Bank of England has averted one crisis, but only by creating another one, inflation. It might be able to deflect the next crisis, and maybe the one after that, but even the most clueless financial commentator can observe that these financial crises are occurring with both increased frequency and severity.

Down in our corner of the antipodes we are a long way from the fiscal constraints past recklessness has imposed on Britain. Our debt-to-GDP is a third of our former colonial masters.

However, not only are we on the same grim trajectory, with monetary and fiscal orthodoxy having been long abandoned; if the increasingly fragile international architecture breaks, we will be caught in the resulting economic shockwaves.