What really brought down Truss?

PRINCETON  —  The resignation of Liz Truss, the United Kingdom’s shortest-serving prime minister, completes a powerful case study of how not to make fiscal policy. But the lesson goes deeper than the idea that British politics was torn apart by a traumatic struggle pitting the government and the Treasury against the Bank of England (BoE). The real failure was overlooking major risks built long ago into the plumbing of the financial system.

The fiscal-policy lesson is powerful because it is so easily personalised. Truss will go into history books alongside Lady Jane Grey, the nine-day queen who died (by execution) in the religious turmoil of sixteenth-century England. In fact, the modern UK is facing the equivalent of a sectarian clash of its own.

The mistake, on the face of it, was the government’s announcement of a £45 billion ($50 billion) unfunded tax reduction, amounting to 2 per cent of GDP, which included a small cut in the basic rate and the removal of the higher income band. The originators of the scheme believed, probably erroneously, that it would stimulate initiative, investment, and thus growth. There was also a more expensive package to subsidise energy consumers, at the time the most generous such program in Europe, amounting to some £200 billion, or 9 per cent of GDP.

These are large figures, of course, but the UK’s public debt level was well below that of the United States, not to mention Italy or the even more extreme case of Japan. The new expenditures and income shortfalls should not, by themselves, turn the UK into a new Greece or Argentina.

Truss’s real mistake may have been to take seriously loose talk about how the era of cheap money and effectively negative interest rates made any kind of public spending a free lunch, since the debt would not have to be paid off and the cost of servicing it was falling. For a while, Modern Monetary Theory (MMT), which used a balance-sheet approach to show that government debt was really an asset of citizens, captivated markets. But then rising inflation, owing to pandemic fiscal packages, supply-chain disruptions, and soaring food and energy prices, obliged central banks with a legal price-stability mandate to tighten monetary policy and consequently to increase the cost of government funding. That cost brought Truss down.

In the interwar period, the central banks in Britain and France pressed left-wing governments running relatively small deficits, generating a widely believed story about a Bankers’ Ramp, what the French called the wall of money. The term was used by the center-left coalition of Édouard Herriot in 1924, when it was shaken by financial instability and eventually collapsed. Ramsay MacDonald’s Labour government met a similar fate in 1931, in the middle of the world depression.

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 paralysing 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.

Harold James, professor of History and International Affairs at Princeton University, is the author of “The War of Words: A Glossary of Globalisation“ (Yale University Press, 2021). Copyright: Project Syndicate, 2022. 

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