The U.K. Market Meltdown Could Be Headed Your Way

The conventional view of Ms. Truss’s rise and unfortunate fall holds that markets took fright after then-Chancellor

Kwasi Kwarteng

on Sept. 23 announced a major package of tax cuts and energy subsidies. This triggered a rout in the market for the pound and government bonds, or gilts, as investors worried about the government’s capacity to pay its bills. Improperly hedged pension funds found themselves forced to sell gilts in ever larger quantities. The Bank of England stabilized the market with emergency gilt purchases, buying time for Ms. Truss and new Chancellor

Jeremy Hunt

to abandon the tax-cut plans that had spooked investors. Once she had done so, order was restored. Her departure will draw a line under this debacle.

It’s such a convenient story that apparently no one in the British press is capable of spotting the holes in it. Yet every sentence in the preceding paragraph is a non sequitur.

The tax-cut package, priced at around £161 billion over five years, was modest compared with the fiscal government blowouts being undertaken in other developed economies. U.K. net borrowing for the current year was expected to increase by £62.4 billion compared with the previous budget, including the cost of energy subsidies. This also couldn’t have surprised markets, since all but a £2 billion (in the first year) tax cut for higher earners already had been signaled by Ms. Truss’s new administration.

Even without spending cuts, the package would have pushed the government deficit to around 7.5% of gross domestic product and debt to around 100% of GDP after five years. That level of indebtedness is far from extraordinary these days.

Then there’s the question of how one gets from a bond selloff to a central-bank bailout for pension funds, of all things. Britain’s defined-benefit pension managers certainly have gotten caught out by the near-catastrophic failure of a hedging strategy designed to sustain them through long periods of ultralow interest rates. Rising rates are triggering collateral calls for these hedges, and if the tax plan hadn’t caused an emergency, something else would have soon.

Stipulate that no central banker or politician wants to preside over the failure of one or more large pension funds. But these funds also didn’t, until three weeks ago, enjoy explicit or implicit backing by the central bank. Nor is it obvious why the central bank should bail them out by intervening in the broader gilt market rather than, say, offering direct assistance to specific funds in jeopardy, as a lender of last resort typically would.

While we’re at it, note another contradiction. Commentators have coalesced around a theory that markets scorned the tax-cut plan because investors feared it would be inflationary. Yet they’ve all seemingly accepted that the proper solution is for the government to backtrack on the central bank’s anti-inflationary policies, as when the Bank of England hints it might further delay its already languid quantitative tightening. And “success” for the central bank and administration alike is measured via falling gilt rates—with a fervent hope that moderating mortgage rates will keep the air in the house-price bubble. Huh?

If the accepted General Theory of Trussonomics doesn’t hold up, try this: The markets’ beef with Trussonomics was that it might have worked.

This episode exposed the astounding fragility of the global financial system after nearly 15 years of extraordinarily low interest rates and quantitative easing. British pension funds literally can’t survive higher rates. Can anyone else?

From this perspective, the central bank’s pension intervention makes more sense. The point wasn’t only to bail out pension funds. It was to reassure everyone else that gilt rates wouldn’t rise too quickly and trigger distress elsewhere. Narrowly tailored support for pensions wouldn’t have accomplished this. High rates rather than insolvent pensions are the real financial-stability threat.

Yet higher rates would be both cause and effect of the sort of economy the supply-sider Ms. Truss wanted to create. She wanted a Britain of faster economic growth but also stronger incentives for productive Main Street investment instead of financial machinations such as the exotic hedging strategies that have failed for pension funds. Indeed, her main criticism of the Bank of England was that it hasn’t raised rates faster to combat inflation (and, left unsaid, to assist a pivot toward productive investment).

Economic growth, which brings with it higher interest rates, might now be viewed by many in the market as a bug rather than a feature. It’s terrible news if so. Britain has shown over the past month that it cowers in the shadow of a financial system that can no longer tolerate productive economic growth or the policies necessary to achieve it. Will other countries find the same to be true for them?