London entered tough financial waters. But Europe now looks more like the UK than it would like. With all the associated risks. In short, it all seems quite clear: on Friday, September 23, the new British prime minister Liz Truss, together with her finance minister Kwasi Kwarteng, presented an interim budget in which, in addition to a colossal amount of energy compensation for households and companies, 45 billion pounds were freed up for tax cuts aimed primarily at the richest households.
Five days later, on Wednesday, September 28, the chaos was complete. The pound plummeted and reached a record low of $ 1.03 on Monday. Ten-year UK interest rates soared to more than 4.5 per cent on Wednesday, the highest level since the financial crisis of 2008 and 2009.
The International Monetary Fund openly criticized Truss’s budget plans, in a tone that is usually only used against emerging countries that have yet to learn.
British banks put their mortgage lending on hold because they no longer knew at what amount they could borrow themselves. Pension funds sounded the alarm. And the British central bank, the Bank of England, could only calm the financial markets on Wednesday with the promise to buy up 5 billion pounds of government loans every day for thirteen days. That supports the rate of those government loans, and a higher rate means a lower interest rate for these types of tradable loans.
After that, the mood in the financial markets turned into a kind of truce. The rate of the pound is back at $ 1.10 – still low, but less dramatic. And the interest rate on ten-year government loans, thanks to the intervention of the central bank, has dropped by half a percentage point, to 4 percent.
The calm may have returned a little, but the damage is great. This of course applies to politics. But also financially and economically, after Brexit and the pandemic, the United Kingdom has suffered New scratches and dents.
Truss and Kwarteng made their way to Canossa on Friday: they went to visit the Independent Office for Budget Responsibility, a budget watchdog they had passed by last week at the presentation of their controversial budge, against every tradition.
Whether the institute has brought them to other ideas was not yet known on Friday during the day. Just before their visit, the latest statistics showed that the UK economy, as the only Western country, is still smaller than it was before the pandemic.
Meanwhile, Truss has put the British central bank in an impossible position. While the Bank of England, like other central banks, raises short-term interest rates to combat inflation, it is now forced to do the exact opposite by buying government loans: keeping long-term interest rates low. PM kicks the brake and accelerator at the same time.
Moreover, the 65 billion pounds of loans that the central bank is now buying up, and against which pounds are being put into circulation, is very similar to the 45 billion (plus the energy compensation) that Quarteng wants to spend.
The term “monetary financing” buzzed around on Wednesday: the mortal sin of a central bank creating money to finance a budget deficit. Literally, and legally, it is not, but it comes pretty close.
It also raises doubts about how long the Bank of England will remain strictly politically independent. Such suspicion alone is extremely bad for the UK’s reputation in the financial markets, of which the country itself is so eager to be the global centre.
In addition, the crisis on Wednesday was also so acute because the British pension funds got into serious trouble. They usually try to use all kinds of financial derivatives such as options, futures contracts and especially swaps to shape their current assets in such a way that it seamlessly matches their future obligations – for example, hoping to free up more capital for risky investments with a higher expected return.
This system of Liability Directed Investment (LDI) is used in many other countries. But the suspicion arises that British pension funds handled it a little rougher and took stronger positions in derivatives.
When the bottom of the market for government loans and other loans threatened to fall on Wednesday in London, the pension funds were urged by their banks to contribute money to compensate for their rising risks on those derivatives. They had to free up that money by selling the government loans they owned, which only made the problem bigger: a so-called doom loop. The Bank of England intervened, in this sense, not to save the prime minister, but the pension system.
That Truss and Kvarteng presented a budget that is stimulating for the economy and increases inequality in the midst of sharply rising inflation is very different from the practice in many other countries. In this sense, the crisis this week was very British – the criticism of the IMF, for example, was also about this.
That is not to say that many other countries, especially in Europe, are more like the United Kingdom at the moment than they would like. London suffers from a twin deficit: a deficit in the budget and in the balance of payments with foreign countries. That makes it very dependent on the whims of international capital.
The Eurozone is vulnerable
Most countries in the eurozone have a budget deficit, but a positive balance of payments. Or rather, they had them. Although there are not many definitive figures yet, it can be assumed that the enormous amounts incurred for the import of energy have also caused the balance of payments in the eurozone to deteriorate sharply this year. The eurozone is also vulnerable.
And buying up government loans by the British central bank while raising interest rates at the same time? That combination of accelerator and brake pedal can also occur in the eurozone. Not only did the massive buying up of government loans by the ECB continue for a long time when inflation was already rising, the central bank has only just stopped doing this.
But if a crisis breaks out around the euro, the ECB can do exactly the same as the Bank of England. The tool has been there since July of this year: the Transmission Protection Instrument. This allows the ECB to buy up government loans in a targeted manner in order to prevent interest rates on government loans in one country (read: Italy) from rising out of step and falling too far out of step with other countries (read: Germany). If the financial markets had reacted with panic on Monday this week to Giorgia Meloni’s election win in Italy, then it could have happened just like that. The ECB was more powerful than the Bank of England.
And then there is what everyone outside the United States has in common: the total dominance of the dollar, the US financial markets and thus also US policy at the moment. The pound lost sharply against the dollar this week, before the rate picked up again. But the euro did the same, and ended up with 0.95 dollars per euro at the lowest rate since the end of 2002. The accrual of interest on government loans, as in the UK, occurs everywhere. In the interest rate markets, the United States sets the tone. The prices of government bonds, and thus the interest rates, in most countries go up and down synchronously to the music from Washington. It’s not just interest rates on ten-year UK government loans that rose sharply this week. The Dutch ten – year interest rate rose to 2.55 percent-the highest since the end of 2011.
This does not detract from the fact that the Truss government dragged this week’s crisis on itself. But European countries, including the Netherlands, have been given an example of how it should not be. It would be good to look at their own pension funds.