Did the Bank of England Sabotage Liz Truss’s Premiership?

Liz Truss has written a 4,000-word essay in the Sunday Telegraph, setting out the case for her own defence. As someone who supported Truss’s leadership campaign (after Kemi Badenoch was eliminated), I found it persuasive. It wasn’t that she was incompetent, although she acknowledges she’s not blameless. Rather, the architect of her demise was “the very powerful economic establishment”, particularly the Treasury and the Bank of England, who opposed her low-tax, high-growth agenda.

The most interesting claim in Truss’s essay is that the economic turmoil that followed her Government’s financial statement on September 23rd was not her fault. The key plank of her defence is that the turmoil was primarily caused by the Bank of England. The Bank’s announcement a couple of days before the mini-Budget that it would only be raising interest rates by 0.5%, lower than the U.S. Federal Reserve, as well as revealing its intention to wind down quantitative easing, spooked the markets. That, in turn, meant the Liability-Driven Investment funds (LDIs) that large U.K. pension funds had signed up to in the hope of increasing their returns suddenly posed a huge financial risk to those funds. Here’s how Liz puts it:

At no point during any of the preparations for the mini-Budget had any concerns about Liability-Driven Investments (LDIs) and the risk they posed to bond markets been mentioned at all to me, the Chancellor or any of our teams by officials at the Treasury. But then, late on the Sunday night, came the jitters from the Asian markets as they opened. I was alerted to this on the Monday morning, at which point the Bank of England Governor was wanting to make a statement on LDIs.

Readers will not be surprised that, given their impact on events, since leaving office I have spent some time looking into LDIs. I was shocked by what I discovered.

In the early 2000s, pension funds were heavily underfunded. To increase their returns, they used LDIs – which use bond derivatives – freeing up cash for the pension funds to invest in other assets. This works when markets are calm but becomes problematic when the price of government bonds falls within a short timeframe. As LDIs entered the financial mainstream, with The Pensions Regulator seemingly encouraging their uptake, warnings started to be issued on the risks they could pose to financial markets – all unbeknownst to me at the time.

Astonishingly, it turns out that the value of total assets in LDI strategies is equivalent to around 60% of the U.K.’s GDP.

The day before the mini-Budget, the Bank of England raised interest rates by 0.5%, whereas the U.S. Federal Reserve had just announced a third successive rate rise of 0.75 per cent. In addition, the Bank simultaneously confirmed plans for a bond-selling programme. Bond prices fell sharply, putting pension funds under pressure.

Dramatic movements in the bond market had already begun, meaning the mini-Budget faced a very difficult environment. Only now can I appreciate what a delicate tinderbox we were dealing with in respect of the LDIs.

It rapidly became a market stability issue and we had to act to stabilise the situation. While the Government was focused on investigating what had happened and taking action to remedy the situation, political and media commentators cast an immediate verdict blaming the mini-Budget. Regrettably, the Government became a useful scapegoat for problems that had been brewing over a number of months. Interest rates had been rising internationally and mortgage costs had been forecast to go up for some time.

Some readers won’t be persuaded by this. Surely, the reason the pound started to plummet against the dollar and the price of 30-year U.K. Government bonds began to fall is because the mini-Budget didn’t include any detail about how her Government’s energy support package was going to be funded? Instead of proposing tax rises to pay for it, Kwasi Kwarteng outlined various tax cuts and reversed the previous Government’s plans to raise National Insurance and Corporation Tax. It was this fiscal incontinence that the markets were punishing, not the action – or inaction – of the Bank of England.

But Truss isn’t the only person making this argument. Liam Halligan expresses the same view in his Telegraph column today in which he urges Jeremy Hunt to reconsider his plans to raise corporation tax from 19% to 25%:

I’m sensing a shift of attitudes towards the market turbulence that followed the mini-Budget – which, of course, led to Truss being ousted from Downing Street.

Over recent weeks, increasing numbers of serious people have started asking me why the Bank of England chose the day before chancellor Kwasi Kwarteng’s statement to become the world’s first major central bank to start unwinding quantitative easing – that is, selling gilts into the market.

That decision on bond sales – plus the lax regulation of liability-driven-investment funds, products dominating the Bank’s own £5 billion pension pot – put the skids under the gilts market irrespective of the Kwarteng/Truss proposals.

This is a debate that has a way to go, with the conventional wisdom – “the mini-Budget trashed the economy” – being seriously challenged.

As far as I’m aware, the first time this argument – it was the Bank of England wot done it – was given a public airing was on October 26th in a piece by Narayana Kocherlakota in the Washington Post entitled ‘Markets Didn’t Oust Truss. The Bank of England Did.’

The common wisdom is that financial markets “punished” Truss’s Government for its fiscal profligacy. But the chastisement was far from universal. Over the three days starting September 23rd, when the Truss Government announced its mini-Budget, the pound fell by 2.2% relative to the euro, and the FTSE 100 stock index declined by 2.2% – notable movements, but hardly enough to bring a government to its knees.

The big change came in the price of 30-year U.K. government bonds, also known as gilts, which experienced a shocking 23% drop. Most of this decline had nothing to do with rational investors revising their beliefs about the U.K.’s long-run prospects. Rather, it stemmed from financial regulators’ failure to limit leverage in U.K. pension funds. These funds had bought long-term gilts with borrowed money and entered derivative contracts to the same effect – positions that generated huge collateral demands when prices fell and yields rose. To raise the necessary cash, they had to sell more gilts, creating a doom loop in which declining prices and forced selling compounded one another.

The Bank of England, as the entity responsible for overseeing the financial system, bears at least part of the blame for this catastrophe. As a result of its regulatory failure, it was forced into an emergency intervention, buying gilts to put a floor on prices. But it refused to extend its support beyond October 14th – even though its purchases of long-term government bonds were fully indemnified by the Treasury. It’s hard to see how that decision aligned with the central bank’s financial-stability mandate, and easy to see how it contributed to the Government’s demise.

Kacherlakota is a former President of the Federal Reserve Bank of Minneapolis, so quite a credible source. However, if you want to read the most hard-hitting version of the pro-Liz side in this debate, I recommend this article in the December/January issue of the Critic by Jon Moynihan, who was one of Truss’s backers in the business world. For anyone interested in this argument, it’s essential reading.

According to this theory of Liz’s demise, she was wrongly blamed for the turmoil in the markets following the mini-Budget – not least by financial journalists, who were too lazy to investigate the causes of that turmoil – and her enemies within the Conservative Party quickly capitalised on that, first forcing her to row back on her pledge to cut the top rate of tax, then getting her to oust her Chancellor, then, finally, forcing her into a dark room with a glass of whisky and a revolver.

No doubt some will see a conspiracy to bring down Liz Truss in all this. But to my mind, it’s just another example of the role that cock-ups and incompetence – as well as impossible-to-predict events – play in high-level political drama, with the conspirators, insofar as there are any, simply taking advantage of unforeseen, last-minute opportunities to topple their opponents and install their allies. But on this occasion, the clowns were in Threadneedle Street, not Downing Street.