Jo Michell looks back at the circumstances that led to the resignation of Liz Truss, concluding that the UK should rethink its macroeconomic governance framework, including the Bank of England’s mandate.
In less than a month, the attempt to recast Conservative economic policy has disintegrated. In a short statement on Monday 17 October, Jeremy Hunt consigned Trussonomics to the history books. By Thursday, its namesake was out of a job.
The ill-fated mini-budget that set this train of events in motion consisted of a range of tax cuts funded by borrowing. The aim was to generate a burst of spending-driven growth ahead of the next general election. In the end, the strategy had collapsed before the policies were even implemented.
The budget was not reversed because the government saw the error of its ways. Instead, the U-turn came only after the country was subjected to an apparent showdown between the Chancellor and the Bank of England, to a backdrop of financial instability.
Markets were showing signs of strain before the mini-budget, perhaps partly due to the announcement of ‘quantitative tightening’: sales of gilts (government debt) by the Bank of England that aim to reverse the quantitative easing introduced in 2010.
The initial market reaction to the mini-budget and Kwarteng’s suggestions of further tax cuts generated rapid increases in the cost of new government borrowing while devaluation of the pound added to inflationary pressure.
Volatility was amplified by feedback loops driven by financial positions held by pension funds. Although higher gilt yields (interest payments on new government borrowing) are good for pension funds because they increase cash inflows, sudden increases in yields can cause problems: pension funds use financial derivatives to ‘hedge’ against the effects of low interest rates, and rapid increases in yields required pension funds to find large amounts of cash to cover ‘margin calls’ on these derivatives.
In response, the Bank of England stepped in with an offer to buy gilts from the pension funds. The intention was to provide pension funds with the cash needed to cover margin calls. Pension funds initially appeared to dither, put off by the low price offered by the Bank. As the deadline for accessing the scheme drew near, Bailey intervened dramatically, publicly remonstrating with pension funds that they had ‘three days left’ to get their houses in order.
At first glance, it appeared that Bailey was abdicating responsibility for financial stability. However, as the dust has settled, the strategic motivation for his actions has become clearer.
Firstly, chastising the pension funds appeared to work – immediately following Bailey’s intervention, the funds sold several billion pounds of gilts to the Bank in exchange for cash.
More importantly, perhaps, Bailey’s ultimatum has been interpreted as also targeting Kwarteng, sending a message that the Bank would not defend the Treasury from the bond markets. In this interpretation, Bailey was effectively challenging Kwarteng and Truss to a game of chicken with the financial markets.
Truss blinked first and within days had sacked her Chancellor and abandoned her economic programme, which in turn led to her own departure from office. Some have argued that the Bank effectively instigated a coup.
In reality is hard to conclusively identify what drove market turbulence, or what the ideal response from the Bank would have been. It could reasonably be claimed that the Bank could not be expected to backstop the Treasury under its current inflation targeting remit.
It should, however, be obvious that this was not an optimal approach to policy-making. The impression that the Bank – an unelected technocratic institution – effectively faced down government economic policy is troubling. In this instance, it prevented the implementation of a regressive and economically questionable policy. But this might not always be the case.
What if a government comes to power in the next two years, elected on promises to invest in public infrastructure and the green transition: would the Bank once again stand aside in the face of renewed pressure from the bond markets?
It may be reasonable to assume that bond holders will look more kindly on investment spending than tax giveaways. Or to assume that the Bank will understand that in the long run, investment is an anti-inflationary policy. But hoping for the goodwill of the markets and the Bank is not sufficient. A new institutional approach to macroeconomic policy is needed.
The current framework is constructed on the basis that monetary policy and fiscal policy can be cleanly separated: the Bank is responsible for setting interest rates so as to control inflation and intervening in markets to ensure financial stability. The Treasury is responsible for taxation, spending and thus government borrowing.
This separation of responsibilities was always overstated – throughout the Bank’s history it has intervened, as it did in recent weeks, to ensure stability in the markets for government debt. Since the adoption of quantitative easing, fiscal policy and monetary policy have been inextricably intertwined.
A new framework is required that reflects this interdependence and provides mechanisms for better policy coordination. A simple change that could provide the Bank with greater flexibility to support government fiscal plans would be the adoption of a so-called dual mandate, such as that held by the US central bank, the Federal Reserve.
Under a dual mandate, the Bank is no longer tasked with targeting inflation alone, but is also expected to ensure low rates of unemployment. This could be augmented with a mechanism for coordination of policy between the Treasury and the Bank.
Such a mandate would acknowledge that the Bank’s powers to determine inflation are limited. This was apparent when the Bank struggled to raise economic activity in the face of austerity imposed by the Treasury. It is also clear that rate hikes are an inadequate tool for dealing with the current situation of rising fuel and food costs.
The recent tug of war between the Bank and the Treasury is only the most recent example of coordination failure.
A dual mandate would reduce the pressure on the Bank to always respond to inflation with interest rate hikes, because such hikes usually also raise unemployment. Instead, the Bank would be expected to take a more balanced approach, reducing the likelihood of situations where the Treasury is trying to expand economic activity and employment while the Bank is pulling the opposite way in an attempt to constrain inflation.
If there is one lesson to take from the last few weeks, it is that renewal of our macroeconomic institutional framework is overdue. The Bank and the Treasury need to be able to work together to foster long-run investment and financial stability. There are better approaches to policy coordination than games of chicken with the financial markets.
By Dr Jo Michell, Associate Professor of Economics, UWE Bristol.