Over the last few months, there has been an awful lot of talk in the media about a collapse in Britain’s economic credibility. Words like spending cuts, tax rises, and the good old days of Conservative austerity have permeated the lingo of public life, but what exactly does all this mean? Exactly who dug this massive hole in Britain’s finances? And what in tarnation is a 10-year Gilt?
It started with Liz Truss. After her divisive win over Rishi Sunak in the summer 2022 Conservative Party leadership election, Liz Truss assumed the mantle of Prime Minister, promising to bring about a new era of economic revival and the end of systematic low growth. She pledged to deliver “a bold plan to cut taxes and grow our economy”, this brand of thought, dubbed ‘Trussonomics’, manifested in her fiscal event delivered to parliament by her chancellor, Kwasi Kwarteng, on 23 September 2022.
Usually, statements such as these are accompanied by a fiscal forecast from the Office for Budget Responsibility (OBR). However, despite an offer of a forecast from the OBR, Truss decided to plough ahead without publishing a financial analysis of her policies. She was, in her own words, ‘“not afraid of being unpopular”’ and this, after all, was merely a small fiscal event. What could go wrong?
Well, say what you will about her grand economic plan, but it certainly lived up to her manifesto pledge of being ‘bold’. Truss initiated a £60 billion energy price guarantee scheme, pledged to increase defence spending by 50 percent, and implemented the largest tax cuts in 50 years. Not bad for a small fiscal event, however the markets weren’t quite so keen. It seems that after considering Liz Truss’s ambitious plan for Britain’s economy, investors ran into the inevitable conclusion that this spending ultimately needed to be paid for and, without the OBR’s analysis, investors couldn’t see any reasonable way of the government meeting its spending commitments for all of these schemes without it resorting to mass borrowing.
This is problematic for several reasons. If investors do not believe that the British government is able to pay for its policies, then they will see Britain as a risky investment. They will withdraw their liquid investments in Britain and move them elsewhere. This process drives down the price of British financial investments, in particular government Gilts.
In Britain, the government borrows money from investors through a financial asset known as a Gilt. A Gilt is essentially an agreement made between an investor and the government wherein the investor agrees to lend the government money for a set amount of time (usually 10 years) until its maturity date, when the government pays the investor back. In return for lending them money, the government agrees to regularly pay a fixed amount to the investor until the bond matures. This is known as the coupon rate. Reduced confidence in the government’s ability to meet its commitments to finance maturing debt results in investors demanding higher coupon rates for newly issued debt. This demanded level is represented by Gilt Yields – the ratio of annual coupon rate to the market price of Gilts, all expressed as a percentage – which show the effective annualised interest rate the government will need to pay in order to borrow. To summarise, the higher the bond yield, the more panicked the government should become.
Liz Truss seems to be the exception to this rule. Truss’s reckless decision to institute mass borrowing with gilt yields at their highest levels since the great financial crash had clearly come from an A-level economics textbook. Her Chancellor, educated in classics and history and with no prior experience at the treasury, was not competent enough to understand the damage that her actions would cause. And so, after 17 days in office, Truss created a supermassive black hole in Britain’s finances, a black hole that threatened to swallow up pension funds, mortgages, and foreign direct investment.
Without intervention from the Bank of England (BoE), who stepped in to save pension funds by buying-up unwanted Gilts, Truss’s economic experiment would have destroyed Britain’s finances and left the British economy crippled for years to come. Yet, in true political fashion, Truss denied any wrongdoing. She blamed the markets, the BoE, the war in Ukraine - anyone but herself. Truss even went as far as replacing her chancellor. Jeremy Hunt was parachuted into office from the Conservative backbenches in the hopes that he may be able to sort out Truss’s mess.
Unfortunately for Truss, her attempts to stabilise her political position were unsuccessful. After a week of Hunt acting as de-facto leader of the country, she resigned. Her resignation makes her the shortest serving PM in history and, given what she did with her limited time in power, perhaps it’s for the best.