The equivalent story for today is already circulating: action by the central bank, as well as the advice of international financial institutions, destroyed a Conservative government that promised to revive growth by fiscal stimulus. The Bankers’ Ramp and international finance now brings down the right, not the left. The countdown to disaster for the Truss government was given when the Bank of England announced that it would end the support scheme for government debt (gilts) on October 14. It was entirely predictable that that would be the day when the government had to promise to rethink its fiscal stance, which Truss did by sacking her chancellor.
Truss’s fall thus appears to have resulted from a clash between what economists call fiscal dominance (the government’s spending promises) and monetary dominance (the central bank’s price-stability mandate). And this time monetary dominance won out, because a new narrative about government profligacy and political responsibility has gripped financial markets, replacing the MMT-infused narrative about the beneficence of public spending and deficits.
But thinking about what happened to Truss in terms of clashing fiscal and monetary policies misses an important and surprising part of the story: the vulnerability of a key part of the UK financial sector to rising interest rates and falling bond prices. The pension-funds industry, committed to paying out on defined-benefits policies, had leveraged its holdings of government debt in order to chase higher returns. If the price of public debt fell because of a rise in interest rates, the funds faced collateral calls. And now, UK pension funds, holding some £1.5 trillion in this kind of scheme, faced a shortage of bonds that could be easily sold. The BOE’s intervention explains the odd shift in government debt prices, with prices for index-linked or inflation-proofed securities falling more than those for regular securities simply because pension funds held so many indexers. Rather than fiscal or monetary dominance, this was financial dominance, with pension obligations paralyzing policy choices.
This trap had been set a generation ago, by the UK Pensions Act of 2004, which was intended to provide greater security or protection for pension-holders by making it harder for pension funds to hold equities. The funds thus had to move into bonds – and into the leveraging strategies, which depended on the bond markets always being liquid. The risk and policy constraints that this created are a much more compelling rebuke to central bankers and financial regulators than the idea of a politicized intervention in October 2022. The fact that the BOE was not directly responsible for financial regulation back in 2004 is a rather feeble excuse.
There was a clear failure by regulators and the broader policy community to identify a mechanism that laid a trap for governments. Truss triggered a peculiarly British mine that might have detonated at any point over the past decade. There may well be other mines out there, in other financial systems. Truss’s failure means that fiscal populism, shared by her predecessor, Boris Johnson, is now ruled out in Britain. But it is also now more dangerous elsewhere. Politicians are no longer free to make big wagers on the future.
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