Beware the bond markets. Bill Clinton’s chief strategist James Carville famously said: “I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 baseball hitter. But now I would want to come back as the bond market. You can intimidate everybody.” What started last week as a loss of confidence in the Truss/Kwarteng commitment to fiscal discipline has now become a risk to international financial stability.
As I wrote a few weeks ago, the Government’s ambition to grow the economy is broadly welcome. The view that the UK economy is not growing fast enough is widely shared. Rather, the negative market reaction to the mini-budget was a product of scepticism that the Government’s policies would meet its stated aims. Without independent forecasts or detailed supply-side reform plans, markets were to a certain extent asked to have faith that the Government could deliver the growth necessary to close the fiscal gap. Markets cannot price plans they have not seen, and as such were extracting a premium for risk in a moment where the global economic situation was itself volatile.
In ordinary circumstances this set of events is not ideal, but we would expect independent institutions, most notably the Bank of England, to mitigate financial instability. The fiscal expansion announced by the Government would have been accompanied by a contractionary monetary policy to counteract potential inflationary impacts and ensure price stability. The Bank of England took this course prior to the fiscal statement by beginning quantitative tightening: that is, selling bonds on its balance sheet.
To be clear, many of the dynamics leading to higher yields were already present in the international economy. Globally, bond yields were rising and markets were becoming stressed. But the mini-budget accelerated these dynamics, and precipitated an even steeper rise in yields in the UK. The result was a liquidity mismatch in the pension market and the threat of insolvency.
This made it very hard for monetary policy to work. The Bank of England was stuck between continuing to tighten monetary policy in response to a fiscal expansion and high levels of inflation, which would risk a financial crisis, or injecting liquidity to maintain financial stability but which adds inflationary pressure.
The Bank of England ultimately chose to continue to inject liquidity because the threat of financial contagion really was significant; it could have spread to money market funds, open-ended investment funds and housing. Financial crisis would have been upon us.
The sheer instability this created in the markets is why the Prime Minister was driven to sack her Chancellor today. The bond markets made credibility an economic imperative, and the Prime Minister had to take dramatic action to show it. The Prime Minister had to reverse herself on corporation tax and announce spending restraint for the same reason. This has moved beyond any particular policy: it is the financial markets demanding their pound of flesh.
If the last two weeks have shown anything, it is that stability and credibility matter when making economic policy. The markets are never just responding to the policy, but to the policymakers themselves and their underlying narrative. This is why the Government’s original gamble was so risky: by asking markets to have faith in a policy without independent forecasts, the Government was in effect putting their own credibility on the line after only a month in office.
The current credibility challenge cannot be understood in isolation either. While there is a crisis in the short-term, we should be worried about the longer-term implications for UK economic policy. Since 2015, the UK has had seven Chancellors; by comparison, the United States has had three Treasury Secretaries, Japan and France have had two finance ministers, Canada three and Italy four; between 2000-2015, the UK had only three Chancellors. Obviously this is only one metric, but it is indicative of the wider problem. Economic policy has been subject to extreme political instability at a moment when stability is at a premium.
The Government has a very narrow path ahead. The UK’s record on productivity, growth, and investment over the last decade has been too weak; the Government is right about that. Any British Government would have to be deeply worried about the growth prospects of the UK economy. A genuine commitment to supply-side and public service reform is welcome. Policy Exchange has written extensively about the reforms that are needed, from planning, to regulation, to childcare.
But it cannot, as this Government has found out, come at the expense of a sense of stability and credibility. By portraying themselves as disruptors, the current Government has narrowed the scope for reforms that are economically necessary but politically difficult.
In writing this I am reminded of my time in Government. New Labour wanted to be, and was in many ways, genuinely transformational. Spending on public services rose, public sector reform became a cornerstone of our agenda, and child poverty fell by a million. But we were able to achieve these things only by ensuring that we maintained economic credibility at every stage – sometimes to the detriment of publicising our policy successes. That same discipline is needed by the Government now. Stability and credibility may not be everything, but as we are finding out, they are nearly everything.
Rt Hon Ruth Kelly is a Senior Fellow at Policy Exchange. She served as MP for Bolton West from 1997 until she stood down in 2010. During this period, she served as Secretary of State for Transport, Secretary of State for Communities and Local Government, Secretary of State for Education and Skills and Minister for Women and Equalities, as well as holding ministerial roles in HM Treasury. Since leaving Parliament, she has held roles at HSBC Global Asset Management and St Mary’s University. She is Chair of Thames Freeport.