Ready, Fire, Aim
The Truss Budget Fiasco
News update: On Monday morning October 17, the new UK Chancellor Jeremy Hunt announced the cancellation of essentially all remaining parts of the Truss/Kwarteng budget announcement. The capital markets rallied in response, but the political future of PM Truss remains in doubt. You can read more about this here and here
In a display of truly staggering incompetence, the UK’s Tory government led by newly appointed Prime Minister Liz Truss and (now former) Chancellor of the Exchequer Kwasi Kwarteng unexpectedly announced three weeks ago the largest tax cuts in recent UK history as part of a major budget-busting initiative which was immediately and roundly panned by the capital markets, the financial and political press, and members of Truss’s own Conservative party. Here is how The Economist summarized the situation at the time:
“In a “fiscal statement” on September 23rd Kwasi Kwarteng, Britain’s new chancellor, promised a “new approach for a new era”. He was as good as his word. In a breezy speech lasting a little under 30 minutes, Mr Kwarteng launched the biggest fiscal intervention by any chancellor in half a century, eviscerated his party’s record in government and sent sterling plunging while gilt yields spiked. He did so in service of an economic goal he is unlikely to reach while diminishing his party’s chances of winning the next election. A new approach indeed.”
As noted, the Truss budget announcement (‘fiscal statement’) stunned the capital markets. On several days there were few or no bids to buy UK gilts at any price, and when gilts did trade they did so at much reduced prices, causing yields to rise as much as 20% (70bp). The FX value of the pound accelerated its recent fall, to near parity with the USD. The capital markets’ initial reaction to the budget announcement was exacerbated as a result of panic selling of gilts by UK pension plans, in an effort to raise cash to meet unanticipated margin calls on large concentrated derivatives positions known as liability-driven investments. The LDIs hedge some portion of the GBP 1.5 trillion of defined-benefit pension liabilities (an amount equal to roughly 65% of the entire UK gilt market), were meant to serve as low-risk hedges and were not only endorsed but encouraged by UK regulators. But while the LDIs did seem to be low-risk for a long period of time, when bond yields were low and stable, LDIs (like most derivatives) are leveraged and subject to margin calls in volatile and sometimes illiquid markets. It’s no wonder that Warren Buffett famously called derivatives like LDIs “financial weapons of mass destruction”. [For more on LDIs, including a comparison of their use by UK and US pension funds, read here.]
In the world of public finance, this is what we call ‘a big effing mess’.
The Bank of England acted promptly in response to the UK’s self-inflicted wounds—deferring the start of its own quantitative tightening bond sales and instead buying gilts from distressed pension funds and expanding its repo program—in an effort to restore much-needed liquidity to the gilt market and ease margin pressure on UK pension funds. But the central bank also indicated that its market support would not be open-ended, in recognition of the urgent need to resume its monetary policy tightening activities in the war on inflation and perhaps suggesting some concern with the growing moral hazard risk associated with central bank market stabilization activities in the UK and elsewhere.
Now roll the picture forward three weeks or so. On Friday morning, October 14th, PM Truss announced a dramatic U-turn on her initial budget announcement, cancelling most of the previously announced tax cuts and reverting to what she had previously called the failed fiscal policies of her Conservative party predecessors. (This is a case that Labour had been trying unsuccessfully to make for years, only to have a Tory PM do it for them, unsolicited and in such spectacular fashion!) At the same time, Truss also fired Chancellor Kwarteng, who had served in his post for only 39 days. Thirty-nine days is of course a very short tenure by any standard, but apparently it is not quite a UK record. The UK record holder, Ian Macleod, served as chancellor for only 30 days in the Heath government (1970). But Macleod died of a heart attack while still in office, which is not quite the same thing as getting fired for incompetence, or as in this case getting thrown under the bus by the co-author of your ill-considered budget proposal. [In the UK, the prime minister is also technically the First Lord of the Treasury. How ironic.]
[We might also note here that at 39 days Mr. Kwarteng served 75% longer than Michael Flynn did as US national security advisor (22 days) and 3.5x longer than Anthony Scaramucci (‘the Mooch’) did as White House communications director (11 days). And while President Trump himself served out his full term (1,460 very long days)—and apparently intended to stay in office a while longer, election results not withstanding— it is quite possible that Ms Truss’s tenure will now be cut short by her own party members. The next UK general election need not be held until January 2025, but the Conservative party can replace Ms Truss as PM with a simple vote of party members without the need for parliamentary action or another general election. This is what the Tories did when they so unceremoniously replaced Boris Johnson with Ms. Truss as PM. I don’t know how likely this is or when it might occur, but I understand there are already bumper stickers in certain parts of London saying “I never thought I’d miss Boris.”]
So what are we to make of all this?
I suppose there are some important lessons (or reminders) here about the adverse consequences of ideologically-driven fiscal policies, the importance of coordinated (or at least not inconsistent) fiscal and monetary policy, and the potential tension between central bank monetary policy and liquidity provisioning in times of high economic and financial uncertainty and stress. But I think the most important lessons to be learned from the Truss budget fiasco—which some UK wags referred to as the ‘KamiKwasi’ budget— relate to the fundamental concept of ‘governance’ and specifically what we mean when we talk about ‘good governance’ in the public and private sectors.
PM Truss made a number of governance mistakes with her recent budget announcement, beginning with its content. Not only were the Truss tax cuts large and unfunded—the package also included large energy subsidies to be paid for by the government—they were also economically unnecessary and likely to prove counter-productive, driving up the rate of inflation and UK borrowing costs while doing little to stimulate economic growth. [Truss and Kwarteng should really have read my post on Reaganomics. They might also have considered that the last time the Tories cut taxes to this extent, fifty years ago, that fatal decision triggered the need for an IMF bailout a few years later, not the sort of thing we generally associate with sound fiscal governance in developed economies.] The Truss/Kwarteng tax cuts seem to have been motivated entirely by political ideology with no regard for empirical economic history let alone the currently fragile state of the economy and the financial markets. In the view of many experts, the Truss budget statement was fundamentally idiotic, a perspective reflected in commentary about the impact of the budget announcement on UK cost of capital due to the increased MRP, which finance students will know as ‘market risk premium’ but which in this context means ‘moron risk premium’.
The Truss budget also seems to have been politically tone deaf, including within the Conservative party, which had only recently promoted Truss to prime minister with far from strong support. And what little political support Ms Truss may have had when she took over as PM has apparently now evaporated, threatening not only Ms Truss’ job but which may also drive the Conservative party from power after 12 long and often painful years. Recent opinion polls indicate that only 20% of the UK public now considers the Tories ‘fit to govern’, a rather shocking statistic given the traditional view of Conservatives as the party of fiscal responsibility.
Good governance is about more than just the content of decisions, however. It is also about following established decision-making procedures, building public support and demonstrating respect for institutional and legal norms. Established governance processes and procedures are important because when followed consistently they tend to increase the quality of decision making, which in turn increases the frequency and predictability of good outcomes. Of course good decisions can sometimes lead to bad outcomes, but not as often (and perhaps not as bad) as truly bad decisions do. Building public support is important in both the public and private sectors, although in somewhat different ways. But building public support involves more than just lining up the necessary votes (at the polls or in the boardroom) to get your proposal implemented; it also involves soliciting constructive input in advance of committing to a course of action and responsively changing course or making concessions when necessary or appropriate. The importance of demonstrating respect for institutional (and legal) norms should go without question, but in today’s world we can unfortunately no longer take this for granted, even in the public sector.
By all accounts the Truss budget failed here too. Traditional decision-making procedures were not followed (eg cabinet level discussions); there was no serious effort made to get public support in advance (even within the Tory party); important institutional norms were side-stepped (eg OBR scoring); and the informed but critical opinions of key individuals were silenced (the top Treasury civil servant was sacked, apparently to smooth the way for the budget announcement). And so when the capital markets, the press, politicians and the public all reacted badly to the budget announcement, the PM and her Chancellor had nowhere to turn for support and no real option other than to throw the entire budget in the trash and hope people would soon forget about it. Which of course they will not.
Good governance is of critical importance in both the public and the private sectors. And while it is sometimes hard to say exactly what good governance looks like—we tend to take good governance for granted because it just seems to happen naturally and without incident in the ordinary course of events—it is generally pretty easy to say what good governance does not look like. Good governance does not look like the management or regulation of AIG Financial Products, Lehman Brothers or Countrywide Financial in the run-up to the 2008 financial crisis. Or the fiscal administration of the State of Illinois or the City of Chicago at pretty much any point during my lifetime. Good governance does not look like Brexit. Or the operation of the Trump White House. Or the governance of companies like Theranos, Enron or WorldCom. And no, good governance does not look like the Truss budget fiasco.
The UK is home to one of the world’s oldest and most stable democracies and you would have thought by now that the Brits would have learned a thing or two about good governance. Which of course they have. For centuries, Britain has been the country that much of the rest of the world looked up to as the model of good governance, in both the public and private sectors, and with good reason. But even the Brits screw up from time to time, and when they do it is sometimes a real doozy, as I think was the case with Brexit and as most of us probably think was the case with the American colonies back in the 18th century.
But after what we Americans have gone through in our own country since the 4th of July 1776, and in light of our own rather spotty governance record over the past decades, we may not be the best ones to point this out.
And from personal experience (16 years in London), I can tell you that the Brits would not take it at all well if we did.
Links
UK Reverses Nearly All Tax Plans to Restore Markets, WSJ, October 17, 2022 (New)
Abrupt Reversal Deepens Crisis for Truss, NYT October 17, 2022 (New)
For Truss and the Tories, a ‘Fairy Tale’ Unravels, NYT, October 14, 2022
UK PM Truss Fires Treasury Chief, U-Turns on Taxes, WSJ October 14, 2022
Bank of England Insists Bond Buying Will End on Friday, WSJ, October 12, 2022
Truss Government is Already Damaged Beyond Repair, The Economist, October 2, 2022
UK Scraps Plan to Cut Tax Rate for Top Earners, WSJ, October 3, 2022
How Liability-Driven Pension Funds Triggered UK Bond Panic, Washington Post, September 29, 2022
This is Truss and Kwarteng’s Crisis, Not Yours, Guardian Opinion, September 28, 2022
UK’s Sweeping Tax Cuts Send Pound Tumbling, Bond Yields Higher, WSJ, September 26, 2022
UK Tax Cuts Collide with Bank of England Plans, WSJ, September 23, 2022
Top Treasury Civil Servant Sacked by Truss, The Guardian, September 8, 2022