Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 18 October 2022

Why it is crucial to understand why financial markets move, rather than worry about the role of markets in aiding the downfall of a Chancellor and Prime Minister



The media sometimes uses a financial crisis in much the same way as religious leaders might have once used natural disasters. Because market moves are the result of the actions of large numbers of traders, who have heterogeneous views and are mainly interested in predicting each other, this allows commentators to say almost whatever they like about the causes of these moves without much fear of being quickly proved wrong. Mysterious or vague language is used, like ‘credibility’. In addition and for the same reason it encourages hysterical pronouncements like ‘there is no floor to sterling’ or ‘no ceiling for interest rates’. In short, financial markets are sometimes treated as a vengeful god, with no shortage of priests around to tell us why it is displeased.

As the commentators the media generally uses to interpret market movements are City economists, this leads to a rightwing bias in such commentary. (It is just a bias: there are of course some very good City economists who are not right wing.) We saw the worst side of this in the UK in 2009 and 2010, when too many City commentators said the markets ‘were looking for austerity’ and without it various disastrous things would happen. As I noted here, half the City economists surveyed by the Financial Times agreed with the nonsensical statement that the 2013 UK economic recovery proved austerity was vindicated.

The market reaction to the Truss/Kwarteng fiscal event was different from this for two reasons. First, because large market moves happened just before and after what was in effect a budget, it was less easy to make up nonsense stories, and in addition many of the economic correspondents commenting on the budget nowadays are rather more grounded than the City economists who thought austerity was a great idea. Second, we have good reasons for thinking that the immediate interpretation of what was happening in the markets as a result of September's ‘fiscal event’ was correct.

September’s market reaction

As there is still some confusion about why the budget led to these market moves, in the appendix I go through the reasons for thinking that the fiscal event substantially increased the uncertainty involved in predicting UK short term interest rates, and therefore in holding sterling assets more generally, using as simple language as I can. However the fiscal event did not increase the chances of the UK government defaulting on its debt, or increase the chances of ‘fiscal dominance’, and nor was it just about the expectation of higher interest rates.

Instead the increase in uncertainty caused by September’s tax cuts was fundamentally about announcing tax cuts without making clear whether or how this would be matched by spending cuts. But it goes further than that. Whatever spending cuts might have been announced, cuts to spending right now are far from credible. A government may promise spending cuts, but with levels of public spending already so low following 2010 austerity, and further squeezed by recent inflation, these cuts may not actually happen. Equally they may be offset by the government being forced to give in to public sector workers whose real pay has steadily fallen in recent years compared to the private sector.

The net result is that tax cuts have produced great uncertainty about the size and economic impact of the spending side of fiscal policy, which translates into uncertainty about the future path of short term UK interest rates, which in turn influences the future return on UK government debt (gilts) and the exchange rate itself. When the future price of a currency’s assets suddenly becomes more uncertain, because most people in the market are risk averse, they want to reduce their exposure to those assets or demand a higher return. Anyone selling those assets, like pension funds, suddenly finds a reluctance to buy.

You can certainly raise a question about whether pension funds should have exposed themselves to this kind of risk, but the risk arose because of the tax cuts in September. However the fact that the Bank of England had to step in as ‘market maker of last resort’ raises uncertainty again, because of what is sometimes called ‘financial dominance’. This is the idea that future Bank monetary policy actions will be compromised because it might lead particular UK financial institutions to get into difficulties. It is an additional level of uncertainty for UK assets above and beyond uncertainty over spending cuts.

Unfortunately I think there is a third and final level of enhanced uncertainty created by September’s tax cuts which goes deeper than those described above. When a group of politicians commit one important act of self-harm, Brexit, you can tell yourself it’s a one off and otherwise the government remains competent. When they do it again, September’s tax cuts, you begin to worry there may be yet more along the line. That is not because the markets are interested in economic competence per se, but because it too could have an impact on the future path of the interest rate the Bank of England sets, and so that also increases the uncertainty involved in holding sterling assets.

The “power of the markets”

When I talked about the market reaction to September’s fiscal event in earlier posts, I received some criticism that I was using a right wing narrative. This was just nonsense: the market reaction happened, and a theme of this post is that it is important to understand why it happened rather than leave that field open to others with an axe to grind. The idea that talking about unsustainable deficits is pandering to an austerity narrative is also nonsense: I have always made it clear that my passionate opposition to austerity does not imply deficits never matter. However there is an ever present worry on the left about the power markets seem to have to occasionally dictate and perhaps even reverse government policy, because it stands in opposition to power won democratically?

I remember being invited to speak at a Labour conference fringe meeting after we had been forced out of the Exchange Rate Mechanism in 1992. That was another occasion where markets struck a fatal blow to the Conservative Party’s economic reputation, yet when I pointed out that currency speculators had done the UK economy a huge favour, there were howls of disapproval from the audience. What I said was true, but to point out that currency speculators had forced sterling to where it ought to be was not popular among that audience.

But that episode and the current one show clearly that the idea that financial markets impose right wing policies on left wing leaders in advanced countries is inaccurate. What financial markets mainly do is try to anticipate future events, and so they can expose the implications of, or ambiguity with, macro policy before either becomes clear to others. The problem, as we have just seen, is invariably with the government’s policy and not the markets. No one would say that firms have illegitimate economic power when they fail to invest because of uncertainty, so why does it make sense to make this statement about financial markets? [1]

What is a problem is treating the markets like a vengeful god, rather than just one part of a macroeconomic system with understandable behaviour. Doing so allows commentators to constantly invoke imagined market reaction as a way of judging policy. In the last week we have seen plenty of this, from those absurdly claiming that September’s market reaction justified austerity [2], to those suggesting the markets are demanding spending cuts. No sensible economist would ever recommend doing what Kwarteng did in his September event, and all the markets did was confirm this fact. It is obvious, therefore, that the best way of restoring market confidence is to reverse all the permanent tax cuts announced in September. It is therefore not surprising that this is what the new Chancellor partially did on Monday.

Does September’s market reaction have lessons for a Labour government after the next general election? In short, no. Nothing in the market reaction to unfunded tax cuts says you cannot borrow to invest in greening the economy. Nothing in the market reaction to unfunded tax cuts says you cannot spend more on public services as long as you raise taxes to do so. What the market reaction to unfunded tax cuts does tell us is that your macroeconomic policy should be transparent, credible and sustainable, and that is something that Labour Chancellors and shadow Chancellors normally understand.

If I had to pinpoint one weakness in a future Labour government’s macro framework, it is maintaining a goal for falling public debt to GDP in the medium term. Nothing in the market reaction to unfunded tax cuts says you need this particular target: Kwarteng said he was going to achieve it in his fiscal event and it made no difference. Such a target potentially conflicts with large scale public investment, and that conflict itself increases uncertainty. Setting targets for medium term current deficits that are sustainable, and implementing tax and credible spending decisions consistent with that, is all fiscal policy needs to maintain market confidence.

To summarise, just as people should have been pleased that the markets forced the government to abandon a ruinous exchange rate peg in 1992, we should also be pleased that the markets have inflicted pain on a government that thought unfunded tax cuts made sense when public services are in dire trouble. The entire Conservative party’s obsession with tax cuts, in an environment where many factors mean the demand for health services will rise as a share of GDP over time, has been and always will be damaging to the UK economy. Brexit, and ‘living with Covid’, have just made that harm more acute. Unfortunately it will require much more than recent events for the Conservative party to understand their error.

[1] There is an entirely separate question about how much an economy should want to expose itself to financial market uncertainty, particularly when that uncertainty might have little to do with your own economy.

[2] To suggest that the only alternative to 2010 austerity were unsustainable deficits is just silly. Good macroeconomic policy is about doing the right thing at the right time. In 2010 the priority was a strong recovery from the deepest recession since WWII, not balancing the books. If, once a strong recovery was complete, deficits were unsustainable then raise taxes or cut spending. By getting the timing horribly wrong, 2010 austerity killed the recovery and we are probably all poorer as a result.

Appendix: why September’s budget influenced the markets

While only the most biased commentators in the media have tried to suggest that the market moves immediately before and after September’s budget had nothing to do with that budget, there remains some disagreement still about the reason why the budget had such a marked effect. At one extreme we have Larry Summers saying “I cannot remember a G10 country with so much debt sustainability risk in its own currency.” At the other we have some saying the reaction was just about anticipation of higher interest rates. While it is impossible to know for sure who is right, I think it is important to be clear what explanations are reasonable and what are not.

There are two ways a government that sells debt in its own currency (called ‘gilts’ in the UK) can default. The first (legal default) is that the government chooses to no longer pay the interest on its debt (or even repay the debt) that it has previously contracted to pay. The second (economic default) is that it inflates away the value of the part of its debt that is fixed in nominal terms. There is no chance that the UK government will legally default, and there is equally no chance that the government will stop the Bank of England using interest rates to try and control inflation. Therefore we can be reasonably sure that the rise in gilt yields just before and after the fiscal event does not reflect changes in expectations about default.

What about the alternative explanation, which is that the market was just anticipating higher short term interest rates. To be clear, the logic is as follows. The ‘fiscal event’ cut taxes. (It also subsidised energy bills, but that had been leaked well before the budget so it cannot explain what happened just before or after the budget. Markets respond only to news.) Lower taxes, if they are not saved, will lead to higher consumption or (with corporation taxes) perhaps investment, which increases aggregate demand. But higher aggregate demand will tend to raise inflation, and the Bank of England is currently raising rates to bring inflation down. So anything that increases aggregate demand will mean the Bank has to raise interest rates further.

We know this is part of the story of what happened, because expectations about short term interest rates did increase. But we also know it is not the full story because of what happened to sterling. If it had been the full story, then expectations of higher short term interest rates would have led to an immediate appreciation in sterling. In fact the opposite happened. Sterling depreciated against the Euro as well as the Dollar. So something else was also going on.

Various people have described the combination of exchange rate depreciation and higher interest rates on UK government debt as reflecting a higher risk premium on UK assets: Krugman (following @darioperkins) called it a ‘moron risk premium’. But what risks are we talking about here, if it isn’t legal default risk or inflation risk? I think it all goes back to the unique feature (at least for the UK over the last few decades) of the ‘fiscal event’, which is that the announced tax cuts were completely unfunded, by which we mean that we had no idea whether they would be paid for by cutting spending or permanently higher borrowing.

That last sentence is a little unfair on the Chancellor. He did say that he remained committed to seeing the government debt to GDP ratio falling in the medium term. If we are being generous in thinking that the Chancellor would not be so foolish to believe that tax cuts paid for themselves, then his statement does imply spending cuts at some time. But that leaves markets with a lot of guesswork to do. We could think about two extreme possibilities.

The first is that the spending cuts would all be pencilled in to occur after the election, with no spending cuts this year or next. The second is that the tax cuts are entirely matched, £ for £, with spending cuts that will take place in each and every year before the election. It is this second possibility which causes the problems, because tax cuts matched by equal spending cuts could reduce aggregate demand, and therefore lead to lower short term interest rates.

The reason goes back to the point that tax cuts can be saved as well as spent. Now if you think a tax cut is permanent, you are inclined to spend all of it, because your post-tax income will be permanently higher. On the other hand if you think a tax cut is temporary, perhaps because the government that made it will lose the next election and the party that wins the election might raise taxes, you will be inclined to save most of the tax cut, unless your income is so low that you need to spend all the money. With the tax cuts in the fiscal event this latter possibility must be quite high, so a lot of the tax cut will be saved.

In contrast, spending cuts tend to feed straight through into aggregate demand. (This includes cuts to welfare payments, because they mainly go to poorer people who have little in savings and so will reduce spending by something close to the amount of the welfare cut.) So tax cuts matched by equal spending cuts will almost certainly reduce aggregate demand, which reduces inflationary pressure and should lead the Bank of England to reduce interest rates.

So we have two possible extremes, and the possibility of some mixture of the two happening. We know that on average markets expected the net effect of the fiscal event and any subsequent budget to be inflationary, but the possibility that after the budget interest rates might be lower cannot be ruled out. What the fiscal event did, therefore, was to increase the uncertainty around future short term interest rates. While the market expected short term interest rates to rise as a result of the fiscal event, there was also the possibility that they might fall because of the subsequent budget.

That uncertainty about what would happen to short term interest rates made sterling assets more risky. If sterling assets become riskier, then we get a depreciation in sterling. Furthermore, unless gilts are held to maturity, their future price becomes more uncertain (because the price of gilts depends on expected future short term interest rates), so you would want a higher return to holding them.

To summarise, because the fiscal event was one sided (unfunded), it increased the uncertainty involved in holding sterling assets, which would lead to a depreciation in sterling and higher returns on UK government debt. This is why calling this effect a moron risk premium is justified, because normally UK governments are not so stupid as to announce tax cuts without saying how they will be paid for.

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