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12 October 2022

How Brexit broke the UK’s fiscal credibility

The UK's financial crisis is the product of years spent ignoring economists and businesses.

By Will Dunn

If you’re a fan of the kind of deep economic uncertainty that has you lying awake at 2am wondering if you should bury some gold in the woods* then get the popcorn ready for this Friday, as Britain careens driverless towards another financial cliff-edge.

For the last ten days, financial analysts have been trying to work out what will happen on Friday (14 October), when the Bank of England winds up the £65bn bond-buying programme that it launched to prevent “widespread financial instability” taking hold after the Chancellor’s announcement of £43bn in tax cuts, funded by new debt. This led to a sharp rise in the yields on gilts, the securities the government uses to sell its debt on financial markets, and sudden losses among the derivatives used by many large pension funds. To cover these losses, those funds prepared to dump tens of billions of pounds’ worth of their own gilts onto a market that had already had quite enough gilts for one evening, thank you, which would have triggered yet more losses.

Speaking at a summit in Washington last night the Bank’s governor, Andrew Bailey, told pension funds: “We will be out by the end of this week… You’ve got three days left now. You’ve got to get this done.” In terms of what the Bank plans to be “out” of, Bailey is referring to this specific market operation rather than the Bank’s wider economic rescue effort, but it’s also a statement that monetary policy has already ceased to work properly and cannot be pushed any further.

The situation will only be resolved if the government can persuade financial markets that its debt won’t grow out of control. Perhaps Kwasi Kwarteng will be able to do this on Monday 31 October, when he announces the government’s Medium Term Fiscal Plan, but he’ll have to be very persuasive indeed. The Institute for Fiscal Studies’ latest outlook for the public finances, released yesterday, says he’ll need to cut £62bn a year from public spending – twice the cuts made during the Cameron-Osborne austerity programme.

“I don’t think the market would believe that would actually happen”, says Tony Yates, the former head of monetary policy strategy at the Bank of England. “There just isn’t enough room to cut that amount of money and get that supported by all the Tory MPs who now think that a decent chance they will lose their seats.”

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[See also: Do voters want to reverse Brexit?]

Simon French, chief economist at Panmure Gordon and a former economic advisor to the Cabinet Office, agrees that governments “don’t suddenly re-establish credibility” with a single event. “It’s lots of smaller actions, as well as the Budget… that will determine whether gilt investors feel the need to run for the door”.

The credibility problem, French says, stems from the “institutional scorched earth policy” that the Truss government has pursued in attempting to silence anyone who might turn up with inconvenient facts – briefing against the Bank’s governor, Andrew Bailey, sacking the Treasury’s long-serving permanent secretary, Tom Scholar, and silencing the Office for Budget Responsibility.

This policy has become embedded in a party that has spent years ignoring economists, businesspeople and citizens in order to maintain that Brexit was a good idea. The handful of contrarian economists who supported Brexit have now moved into Trussonomics.

“In calls I make with US clients”, says French “they say ‘so let me get this straight: the same people who said that Brexit would lead to sunlit uplands are now saying this Growth Plan is going to deliver two and a half per cent trend growth, in an economy that has averaged about half that over the last decade. Riiight.’”

Truss and Kwarteng are perfectly entitled to rail against the Davos Men of the greenwashed centrist neoliberal orthdoxoy. But what they have failed to grasp is that if you want to raise money by selling debt on financial markets, you are going to have to sell it to a whole bunch of Davos Men (29.3 per cent of gilts are owned overseas), and they will price it based on their confidence in your fiscal plans, not yours.

“It’s weird to think that they didn’t think that through”, says Tony Yates, “the fact that no-one else would think it would work – because there’s no evidence that it does work – and that that would therefore make everyone shit themselves about public finances.”

This is currently an appropriate reaction to public finances because at this point, the big worry for the Bank and the government is that auctions for public debt will start to be “undersubscribed”. If investors won’t turn up to lend the government money, the government can’t finance public services. “I don’t think it’s going to get to that,” says Yates, “but we’re into that territory.”

As with the other disasters Brexit has caused, the most likely outcome will be yet more political upheaval. It’s possible the Chancellor could leave in early November, but it remains to be seen how much time this would buy the PM. The great irony of the Truss government is that the one thing that may settle markets is the probability that it won’t be around for long.

*(This is not investment advice; do not bury any gold in the woods.)

[See also: Kwasi Kwarteng makes a cautious retreat]

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