30 September 2022
Much ink has been spilled this week on how the UK Government’s mini-budget either ‘spooked’ or ‘frightened’ the markets, giving the rather silly impression that markets are either afraid of the supernatural or bizarrely timid, and that the world’s markets should be viewed as having a single collective opinion.
The problem with such terms is that they obscure what actually happens, and therefore what might happen, and maybe even how best to respond. A better approach is to see ‘markets’ as interactions between different markets with different players pursuing different objectives. As a result of these interactions, the macroeconomic outcome can be much bigger than the initial trigger and very different to what any single market participant had in mind.
First, the mini-budget. The biggest announcements (reversal of the National Insurance rise and cancellation of the planned increase in Corporation Tax) were trailed well in advance and could not have come as a surprise to anyone. The rest was some dreadful tax changes that probably do more harm than good, and ‘supply side’ measures that are either unlikely to be delivered or inconsequential.
The big surprise was the lack of substantive measures to pay for the giveaways. Worse still – there was an open promise of more to come.
And there is some form here. After the enormous and very necessary support during Covid, there was no attempt to recoup some of the expense from the massive rise in bank deposits after the economy had recovered. Even the Energy Price Cap provides a windfall gain to energy producers using sources other than gas. Since two thirds of our energy consumption comes from domestic producers then this provides another huge transfer.
Now, such largesse may be a good idea at a time of high unemployment, weak output or when there is plenty of room to grow For example, during the years after the global financial crisis.
But this time it’s different. Unemployment is 3.6%, job vacancies are near a record high and the labour force is barely growing because of the long-term sick. The public sector debt burden is heading to over 100% and potential growth is 1.5% at best rather than the 2.5% the government is targeting.
Even before the mini-budget, market-implied forward rates suggested a Bank Rate of 5%. Once the size of the unfunded tax-cuts became clear – and so the amount of debt to be sold – a cool one trillion pounds over four years, one can understand why investors might need a cheaper price and currency to buy some gilts. So much for the immediate response.
Interacting markets can amplify the impact. The amount of funding created volatility in the government bond or gilt markets. A first consequences was for banks swapping cash flows used to hedge mortgage risk. All of a sudden, mortgages started to get withdrawn. A second consequence was for a very different set of investors – pension funds which use gilts as collateral to hedge swings in the present value of their liabilities.
The next actor to become involved was the Bank of England, which had to act as the ‘market maker of last resort’ by buying up to £65bn of gilts to assist illiquid but highly solvent pension funds. This response is entirely consistent with its financial stability mandate, but faces in the opposite direction to its intended monetary policy stance. The Bank must always prioritise financial stability and responded impressively.
Which will be the next interacting market? One of them will be the housing market. At the time of writing the forward markets are expecting a Bank Rate of over 6%, by the middle of next year which will feed through into swap markets and ultimately mortgages. And the flow of mortgages has already been interrupted at a time when the house price to income ratio is at its highest. This will then have consequences for the wider economy.
All of which is to say, that the ultimate impact of connected, but different, financial markets each responding in turn may be much greater than the original sin. It is less a fear of the supernatural or hyper-sensitivity than amplification processes through connected financial markets. Amplification is not inevitable, but then that gets us into institutional design.
None of this will be lost on the Government. The most likely course of action is that they try to reverse what they have started by announcing some hefty spending cuts. But the real world is path dependent: it is never possible to go back to exactly where you started. It is unlikely that all of the damage can be fully unwound meaning that there will be further macroeconomic consequences.
A final thought: Paul Krugman said in his New York Times blog this week that the idea that events in the UK could have global consequences was absurd – the UK is just too small.
Similar comments were made about the sub-prime market back in 2007. UK gilts are one of the most important forms of collateral traded in global financial markets, and financial markets can amplify greatly an initial error. It is no wonder that the IMF is watching.
Angus Armstrong is Director of the ESRC funded Rebuilding Macroeconomics network at the Institute for Global Prosperity. Rebuilding Macroeconomics aims to transform macroeconomics back into a policy relevant social science.
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