What we can learn from the past week’s market ructions

Here is how the script used to go. South European countries suffer from chronic political instability, have weak public finances and have given up their own currency, so financial market meltdowns are just waiting to happen. The UK, in contrast, has retained its currency and knows how to manage markets, so it has both more room for manoeuvre and the skill to navigate it better.

Surely the past week must have convinced the last true believers to bin that script. Italy had an election that put far-right Giorgia Meloni in a position to lead a new Italian government that will be a mix of inexperience and the very wrong kind of experience. Yet it was the UK’s new government that triggered a financial market panic with the mini-Budget presented last Friday by Kwasi Kwarteng, the UK’s new chancellor.

The opposite has transpired. Not that Italians got off scot-free: as of Wednesday night, Rome’s 10-year borrowing costs had risen by 0.5 percentage points since last Thursday morning, with the increase peaking at 0.7 points a little earlier. Government bond yields have risen elsewhere too. But the UK’s 10-year gilt yield jumped 1.2 percentage points in just a few days. It was only after a dramatic intervention by the Bank of England that the increase moderated to 0.7 percentage points on the week.

The pound fell too, dropping to record lows against the dollar. That is a poor indicator, however, because the dollar has been “smashing almost everything in sight”, as Robin Wigglesworth puts it, including the euro, which now trades well below parity. Still, the pound has lost about 3 per cent of its value even against the euro since last Friday morning.

Above all, there was real disruption where the financial markets meet the real economy: hundreds of mortgage products were abruptly withdrawn, and pension funds suddenly found themselves squeezed as plunging government bond prices wreaked havoc with their balance sheets. That was the prompt for the Bank of England’s intervention (on which more below).

So in a comparison with Italy, the UK comes off worse if judged by many financial market metrics. That is not what Friday’s statement by the chancellor was supposed to achieve. On the contrary; this was the occasion to set out a “growth plan” that was supposed to show how a Brexit Britain could be run differently from the EU model it had thrown off. What happened?

The most-told story is one of borrowing pushed too far, and lenders pulling out — what Brad Setser calls an external funding crisis, and once seen as a risk to the US brought on by its combined fiscal and current account deficit (sounds familiar, UK?). If the British government just went beyond what financial markets thought was sustainable, higher borrowing costs and a weaker pound were to be expected. In other words, a sort of balance-of-payments crisis and government-funding crisis combo, just the kind of problem many have blamed on the euro in the past.

Another, not mutually exclusive, explanation is that the mini-Budget’s fiscal stance is inflationary, to an extent that the BoE will struggle to offset, either because it is loath to tighten enough or because the government will pressure it not to. Market fear of such “fiscal dominance” would also naturally lead traders to sell off both UK government bonds and the pound. But I am sceptical. First, there is no sign that inflation expectations actually increased in response to Friday’s mini-Budget; indeed, on some market-based measures they have fallen.

But, second, it is a central problem for both explanations that the mini-Budget contained hardly any news at all. In the days before the mini-Budget, the excellent Institute for Fiscal Studies produced public finance projections based on what press reports said would be in the announcements, which turned out to be almost spot on. Both the fiscal stance and the debt implications were well absorbed by markets before the chancellor gave his speech.

The one “rabbit out of the hat” policy was to abolish the highest rate of income tax, which will make very rich people quite a bit richer but only loses the government a few billion pounds in annual revenue — not enough to move the needle for those assessing governments’ creditworthiness or really for the BoE’s interest rate calibration. In a research note, Nomura’s Europe economists put the cost of previously unknown policies at a modest 0.25 per cent of gross domestic product on average for the next five years.

The fact that any vandalism to the economy or the public finances was already well known makes me hesitate to attribute the panic to the content of the mini-Budget. It also makes me hesitate about a widely held view that the panic will continue or worsen unless the government reverses course on its tax cuts or sets out a package of spending cuts to pay for them. (This hesitation is, of course, also informed by my view, not shared by many, that the overall macroeconomic stance is tightening too much everywhere, and that we should treat accumulated debt with benign neglect.)

Nomura’s conclusion seems closer to the mark. The huge market reaction, its analysts think, was “not because the chancellor did a lot more over and above what he said the Treasury would do, but rather because it signalled ‘intent’ for potentially further policy easing ahead and a lack of deference to the UK’s fiscal police (ie, the Office for Budget Responsibility)”.

More tone than content, in other words. As Robert Shrimsley reminds us, the new government is the latest (and, so far, perhaps the purest) incarnation of the movement that produced Brexit, which has proved itself perfectly willing to cause economic damage and undermine Britain’s institutions, while denying any such thing and deepening political polarisation in the process.

So maybe it was just that the statement finally convinced investors and financial traders of the government’s pigheadedness. It exposed the country’s leaders as ignoramuses who have drunk their own Kool-Aid and genuinely believe growth will come from policies that have neither “evidence nor experience” in their favour, as Minouche Shafik lays out perfectly in an FT op-ed, and as John Van Reenen does in a blog. It also demonstrated a willingness to plough on with a politically destabilising programme — this profile of Kwarteng is instructive in that regard. The talk is already of whether the Conservative party will let the chancellor or even the prime minister herself survive — which, in turn, can’t be good for the economy.

Simply put, Kwarteng’s “plan for growth” announcement convinced most sensible people that the UK’s growth prospects just got worse. Markets got to know the attitude behind the policies, and didn’t like what they saw, explaining a generalised sell-off. In a sense, the Brexit bunker mentality is right: everyone else is “woke”, insofar as “woke” means thinking that growth relies on investment, a functioning state and political predictability.

What all this implies is that there is no way back. We should see the market panic as a correction; a one-off adjustment of prices that were mismatched to the nature of the current government. Things could well stabilise at this new level, and neither return to previous values even with a policy change (because markets would not unlearn what it has learnt about the new government) nor get worse without one. We are where we are.

Instead, this episode raises some other hard questions, especially for the BoE.

Like its counterparts elsewhere, the central bank is set on a course of raising interest rates significantly. In the past week, markets have done a lot of the job for them. The results show that those who think they should have tightened more and faster should be careful what they wish for. The sharp rise in UK mortgage costs is just one illustration of the pain monetary tightening was always going to entail. More and more will be asking whether this is really what the economy needs.

The BoE struggles to communicate what it now wants to do. Its chief economist has signalled that the market panic calls for further tightening. But it was open to the bank to say the opposite: precisely because the market had strongly tightened financial conditions of its own accord, the monetary policymakers could hold off for some time. The problem here is that the BoE leaves it unknown (and may, in fact, not know) which market financial conditions — long-term gilt yields, say — are appropriate for the economy. It does not help that UK fiscal policy is now explicitly at cross-purposes with its monetary policy: the Treasury seems to be aiming for a looser overall macroeconomic stance than the bank. That is the opposite of macroeconomic policy co-ordination.

And all of that comes before the breakdown in the gilt market that forced the BoE to intervene on Wednesday. The short story is that as gilt yields rose abruptly, pension funds that had hedged against interest rate changes were forced to present more cash as collateral to their counterparties, which they could only get by selling gilts, thereby fuelling a spiralling sell-off. (For more details, read Alphaville’s explainer.) As Timothy Ash points out, this was a disaster waiting to happen. If the financial market cannot absorb a fast rise in rates without risking serious disruption, that poses two questions. Why did regulators permit this situation to develop — is it worth letting pension funds take these (in normal times small) risks? And what does it mean for the central bank’s ability to raise rates as the macroeconomic situation requires?

To be clear, the central bank was certainly right to intervene to buy bonds and stabilise the situation. But having announced it would start selling bonds last week, only to start buying them again, while promising to start selling in a few weeks’ time, is confusing at best and contradictory at worst. If this means our financial systems can’t cope with certain monetary policy paths, we have a problem. And it’s a problem that applies much more widely than in the UK. Remember that a similar “dash for cash” caused a sell-off in US Treasuries two years ago, and that similar pressures are present in US Treasury markets today.

All this points to deep incoherence, or at least unpreparedness, for the monetary tightening cycle most people are telling us we need. If financial markets are so sensitive to moves in longer-term government bonds, then why should central banks not focus more on controlling those rather than the short rates? We know two things. First, that if monetary policy controlled long yields, changing them gradually as the macroeconomic picture required, this week’s UK pension funds debacle would not have happened. Second, that central banks can choose to target long rates: the Bank of Japan has, for years, demonstrated how. Other central banks have adopted Japanese policies before. It seems time to consider doing so again.

Other readables

• Pew Research documents show how the rest of the world increasingly takes a negative view of China.

• In response to my recent piece on expectations and beliefs, the IMF’s Fuad Hasanov shared an essay on narratives in policy choices for economic growth.

• The International Telecommunication Union is choosing its next secretary-general — and if that doesn’t interest you, it should.

Numbers news

• Four-fifths of producer price inflation in Europe can be attributed to supply-side factors rather than high demand.

• The European Bank for Reconstruction and Development projects higher growth in central Asia and the Caucasus, even as Russian president Vladimir Putin’s war on Ukraine devastates economies elsewhere. One reason is that the region has benefited from new transport routes in response to sanctions on Russia, as this article explains.