#240: Trussed for the block?


New British premier Liz Truss, and her chancellor (finance minister) Kwasi Kwarteng, have embarked on a gigantic economic gamble. If it succeeds, it will surprise, not just “trickle-down”-averse Joe Biden, but everyone who understands the realities of post-abundance economics.

If it fails, it’s likely to induce a “Sterling crisis”, with disastrous consequences for the costs of imports, and of servicing debts denominated in foreign currencies.

The verdict on this gamble will be passed, not by the voters, but by the currency and gilts (government bonds) markets. So far, a few hours after the chancellor’s statement, it’s not looking good, with Sterling down to just above $1.10. Investors are understandably reluctant to buy a pig in a poke, particularly when a detailed price-tag hasn’t been attached to it.

Many things are extraordinary about this gambit. It’s not new, of course, for governments to prioritize the greedy over the needy, but they are seldom quite so brazen about it. The Truss administration seems to be at war with permanent officials, and has already sacked the senior civil servant at the Treasury. For the first time since the Office for Budget responsibility was created back in 2010, the advice of the OBR has not been sought, and its economic and fiscal forecasts have not been published.

This site doesn’t ‘do’ party politics, still less the politics of personality, and our focus is on the economy understood – as it should be – as an energy system. But we’re entitled to comment when the government of a major Western economy takes extraordinary risks in pursuit of objectives that aren’t feasible, using policies that aren’t credible.

The Truss government has nailed its colours to the mast of economic “growth”. There are two main planks to this platform. One is the contention that, by borrowing now, an economy can generate enough growth to pay off, in the future, the additional debt incurred in the present. The second is that hand-outs to the better off will percolate through to benefit the less fortunate.

On the latter, Mr Biden has remarked within the last few days that he is “sick and tired of trickle-down economics. It has never worked”. It’s noteworthy that the term “trickle-down economics” is never used by those who advocate it, for the sufficient reason that it’s utter gobbledygook.

Mention of America, though, should remind us that Ms Truss, like her predecessor Mr Johnson, has no misgivings about antagonising Britain’s allies and trading partners. Mr Biden has already made it clear that a trade deal between Britain and the United States – the trophy promised and sought by so many supporters of “Brexit” – isn’t going to happen. The UK seems quite prepared to antagonize the EU – and, again, the White House – by reneging on a treaty determining trade arrangements affecting Northern Ireland.

Political analysts might observe, in this situation, a transference of weakness from party politics to national economics. Liz Truss’s own political fragility is being parlayed into worsening the economic and financial fragility of the British economy.

Ms Truss was not the preferred candidate of Conservative MPs, whose own choice was Rishi Sunak. Her ministerial changes have sent a large cadre of the disaffected to the back-benches. She owes her elevation to party members, a tiny and unrepresentative sliver (0.2%) of the British public. Many, even of those, might have preferred to reinstate Mr Johnson if his name had been on the ballot.

If there’s a Tory precedent here, it’s Benjamin Disraeli (1804-81). His great triumph, the Reform Act of 1867, was achieved by outflanking Mr Gladstone’s Liberals from the left. This seemingly left voters baffled by the difference, if any, between “Dizzystone and Gladraeli”. He may or may not – but it was in character – have said to a dissenting MP “damn your principles! Stick to your party!”. On his elevation to prime minister in 1868, he was wont to say that he had “reached the top of the greasy pole”, the big challenge now being to stay there.  

From an economic perspective, the problem with the new economic gambit is that it’s impossible – in Britain, or anywhere else – to buy growth with debt to a point at which the expanded economy then pays down the incremental borrowing.

Between 1999 and pre-covid 2019, the UK economy expanded by £0.72 trillion whilst increasing aggregate debt by £2.9tn. An equation in which each £1 of borrowing yields less than £0.25 of growth makes it impossible to a pull a rabbit of solvency out of the top hat of debt.

Analysis undertaken using the SEEDS economic model shows that, between 2001 and 2021, British real GDP increased by £560bn (at constant 2021 values) whilst debt soared by £2.93tn, a borrowing-to-growth ratio of 5.22:1. Within the “growth” reported over that period, fully 69% was the purely cosmetic effect of pouring so much extra credit into the system. Reported growth may have averaged 1.8% annually over that period, but annual borrowing averaged 7.2% of GDP.

Organic growth – calculated here as underlying or ‘clean’ economic output (C-GDP) – averaged only 0.6%, rather than 1.8%, through that period. This rate of underlying growth in economic output was less than the trend increase in population numbers (0.77%) through those same years.

Fig. 1

When we further factor-in rises in the Energy Cost of Energy (ECoE), it emerges that British prosperity per capita topped out in 2004, at £27,900 per person, and had, by 2021, fallen by 10%, to £25,090.

At the same time, the estimated real cost of essentials has been rising, even before the recent surge in energy prices. As you can see in the left-hand chart in fig. 2, the average British person is subject to relentless affordability compression. This is reflected in the second chart, which plots relentless contraction in the affordability of discretionary (non-essential) purchases.

This ‘affordability compression’ can be expected to undermine the ability of households to ‘keep up the payments’ on everything from mortgages and credit to staged payments and subscriptions. This is particularly important in an economy extensively leveraged to the global financial system. Despite some contraction in the aftermath of the global financial crisis, British financial exposure remains enormous. When last reported at the end of 2020, financial assets – the counterparts of the liabilities of the household, business and government sectors – stood at 1262% of GDP, far higher than the United States (588%), the Euro Area (795%) or Japan (871%).

Fig. 2.

We need to be clear that SEEDS analyses of other Western economies display, for the most part, patterns that are not dissimilar to those of the United Kingdom. As a direct result of relentless rises in ECoEs, Western prosperity turned down well before the 2008-09 global financial crisis (GFC). The idea that a deterioration in material prosperity can be countered with financial innovation has been a delusion shared by governments around the world.

Where Britain is different is in the government’s preparedness to gamble, and to insist that political will can triumph over economic reality. Though subjected to much criticism, the Bank of England has been doing its best to persuade the international markets that Sterling remains an investment-grade currency, despite the reckless behaviour of its bosses in Westminster. The Bank knows, as the government seemingly does not, that the economic viability of the United Kingdom rests on the credibility of its currency.

The probability has to be that the Truss administration’s gamble will fail. As well as not putting a price-tag on the full-year cost of its energy support programme and its generally regressive tax cuts, nothing has been said about public spending, particularly on health and defence.

What Mr Kwarteng offered the markets today was an un-costed exercise in bluster. The probable consequences are, at the least, weaker Sterling, costlier imports, rising rates and – irony of ironies, where Conservative supporters’ priorities are concerned – falling property prices.

The full consequences won’t be known until it’s clear how much the government needs to borrow, whether investors are willing to lend to it and, if so, at what price.

187 thoughts on “#240: Trussed for the block?

  1. Ahh the world of make believe makes for gripping entertainment. All this over play monies. Fiat, ain’t it fun. Too bad it isn’t like watching sci-fi and we could just turn it off. Interesting times for sure as most of the western general public get a steep learning curve in finance. Great insight of course from Dr.T and all contributors. Thanks goes out to all!

  2. Pension funds invest in government bonds so why set-up LDIs to buy more as a hedge to ensure their liabilities to pension holders in the future are paid in full?

    This sounds like another insane situation of unregulated leveraged speculation.

    How can they be allowed (LDIs) to keep buying bonds to raise cash then pledging those bonds as collateral to buy even more like a damn ponies scheme?

    £1 trillion market?

    You gotta be kidding me with this stuff.

    This is CDO “AAA” rated junk stupidity kind of level investing.

    I am seeing some people say the UK pension obligations are £10 trillion plus.

    How much is invested over that as a hedge/speculation?

    Regardless, the BOE should not be bailing them out.

    Let them go bankrupt. No more pension? Tough. You win some you lose some.

    This is not going to end well.

    • There is an article on Wolfstreet about it. The comments are as ever interesting. The quants and whizzkids devised a hedging model which seems to have decoupled from reality……which forced the BOE to step in “temporarily”. Now when has that happened before? And what was the Pension Regulator doing about this? Apparently £1 trn of pension fund assets was at stake!!

    • Quite so. At the root of it, this is a leverage story, and Wolf explains this very well.

      Leverage increases returns whilst simultaneously increasing risk. Pension funds are part of the NBFI (non-bank financial intermediaries) sector, sometimes called ‘the shadow banking system’. We discussed this recently in #238.

      And yes, the comments are very interesting. The general tenor seems to include the view that the UK has gone off a cliff.

      Forgive me if this sounds like plugging Surplus Energy Economics, but we have seen this coming………

    • From what I can tell, QE is being used to hedge markets. In a sense hedge the hedgers and confuse the hell out them.

      The BoE has unlimited reserves of fiat currency to play the market activists at their own game and as long as we make the right bets, we win they lose.

      However, I’m not entirely sure about the effects of holding ‘unlimited’ bonds on BoE balance sheets. I can only imagine the financial markets and institutions can puff puff and puff but not blow the house down despite the derivatives market being estimated to be over $1 quadrillion on the high end.

      With some market analysts placing the size of the market at more than 10 times that of the total world gross domestic product (GDP), if they become overtly political and coordinated, I’m assuming they would have the power to destabilise countries at will.

    • “Pension funds invest in government bonds so why set-up LDIs to buy more as a hedge to ensure their liabilities to pension holders in the future are paid in full?”

      so this near blowout today must have its roots in prior years.

      if UK pension funds had been “healthy”, it seems to me that there would have been no need to create leveraged bond buying schemes.

      at some point in the recent past, these UK pension funds must have been getting “unhealthy”.


    • I would refer you to #238. Money and the end of abundance, in which we discussed non-bank credit providers. These lenders use govt. bonds as collateral, which is leveraged to provide loans. This sort of leverage provides enhanced profits in the good times, and enhanced risk in the bad. UK exposure to the broader financial system is more than 12x GDP. Unlike deposit-taking institutions, the ‘shadow banking system’ isn’t regulated.

      You will recall that I subtitled that article “A financial crisis primer”…………..

    • thanks, I’ll quote your link:

      “In an article published in 2021, Ann Pettifor provided a succinct description of the shadow banking system. She traces the rise of the sector to the privatisation of pension funds, which happened in 30 countries between 1981 and 2014, and which, she says, “generated vast cash pools for institutional investors”.
      Shadow banking participants “exchange the savings they hold for collateral”, generally in the form of bonds, usually government bonds. Instead of charging interest, they enter into repurchase (repo) agreements whereby the borrower undertakes to buy back the bonds at a higher price.
      She points out that securities “are swapped for cash over alarmingly short periods”, and that “operators in the system have the legal right to re-use a security to leverage additional borrowing. This is akin to raising money by re-mortgaging the same property several times over. Like the banks, they are effectively creating money (or shadow money, if you like), but they are doing so without any obligation to comply with the old rules and regulations that commercial banks have to follow”…”

      enhanced RISK, indeed.

      your conclusion:

      “The biggest danger of the lot, though, is an implosion within the credit sector, affecting not just banks but NBFIs as well. Here, market participants may – for some time, at least – hold their nerve, placing their trust in the (actually impossible) assumption that, as in 2008-09, governments and central banks will intervene to backstop the system.

      Eventually, though, the network of interconnected liabilities will start to unravel, in a similar (though vastly larger) re-run of the ‘credit crunch’ of 2007. At this point, credit flows dry up, because nobody knows which counter-parties are or are not viable.

      “All roads”, it’s said, “lead to Rome”, but all of the discernible trends in the financial system point to financial implosion.

      As abundance ends, so, too, must any system that is predicated entirely on its infinite continuance.”

      THERE IT IS… “governments and central banks will intervene to…”

      delay the inevitable financial implosion.

    • Thanks David.

      What I aimed to do in #238 was (A) to describe the inter-connected, vastly-leveraged broader financial system concisely, with minimal use of jargon; and (B) to try to put some global numbers on it. This is stuff that we all need to know about, in addition to our understanding of the economy as an energy system.

  3. Pingback: Britain's desperate economic gamble - Radix Think Tank

  4. T.G.C. is ‘optimistic’?
    “The difficult period will be in the rest of this year and 2023. However, the world does not suffer from a fundamental shortage of natural gas. Indeed, discovered reserves at the end of 2020 were equal to 48.8 years of production, according to BP’s latest Statistical Review of World Energy ?

    At present the gap between them is extraordinary, with natural gas in the USA at under $10 for a million British thermal units and in Europe over $60. ”

    Click to access 2022_The_Critic_October_Gas_prices_inflation.pdf

    ‘A figure of 2 per cent of GDP is probably about right as a measure of the maximum hit to the UK’s “real national purchasing power” in the worst-affected one-year period. This is a problem, but it is manageable and far from unprecedented “

  5. Tim, you have every right to plug your blog. It (and the high-quality comments – including my own of course!) have made far more sense for far longer than the overpaid talking heads in the mainstream media, etc.

    Some thoughts (would be interested in the views of others):

    1. Why have defined benefit pension schemes been allowed to get so exposed that they effectively need a colossal bailout (which is in effect unaffordable)? This seems a worldwide, not just a UK issue. As you, Tim, have said, the next financial crisis is going to test the very viability of fiat currencies. There cannot be any justification for dumping the costs of bailing out such pension schemes on the public, most of whom have no access to their benefits.
    2. The BOE has been very hesitant about defending Sterling and has now largely given up…..presumably to protect house prices in the run-up to an election. There will be massive pressure on the rate setters not to go higher. The Tories know that they will be destroyed if house prices crash before 2024. Even if inaction leads to Sterling tanking, they will hope that it impacts people less directly, can be blamed on other factors and they can defer dealing with it. A big gamble but their sole focus is on staying in office.
    3. The focus is on Sterling but the Euro has all the same issues plus the huge problem of Club Med’s debts, especially Italy. The ECB is making hawkish noises…..but will they back off too?
    3. I see Mark Carney has jumped on the bandwagon. As the high priest of ultra low interest rates and house price inflation (in both the UK and Canada), his best contribution would have been a lengthy period of silence.

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