Background image: Getty Images
There are important lessons to be gleaned from the sterling plunge and gilt market crash in September off the back of an ill-conceived “mini” Budget. Politicians should be wary of the market’s power, Tim Skeet writes.
It’s ironic how sometimes history can repeat itself, especially when it really shouldn’t. The unveiling of the so-called “mini” Budget or “Growth Plan” by the then chancellor Kwasi Kwarteng on September 23 unleashed irresistible forces that had a traumatic market impact — something which should not have come as a complete surprise.
Decisions were taken on the back of very little technical advice or guidance, with the result that the plans laid out on that fateful day had a dramatic effect. The gilt market crashed and sterling plummeted. Chancellors and their advisers should have known better.
In a free market economy, who really has the upper hand — political masters or market masters? It is now 30 years since the UK public authorities first learnt the painful lesson that financial markets require deft handling and respect.
It was back in 1992 that central banks and their governments first clearly discovered that free financial markets had become more powerful than them. Three decades later, another Conservative government and a different market (gilts, not foreign exchange) came to a similar conclusion.
The 1992 crisis was an international affair centred on the foreign exchange market. Few working today might clearly remember the fateful day, September 16 — ‘Black Wednesday’ — when the Exchange Rate Mechanism (ERM) unravelled.
The Bank of England (BoE) pushed its overnight rate up to 15%, while the Swedish Riksbank moved its own reference rate to an eye-watering 500%. All this was to no avail and the market won. The ERM failed. Politicians and the public paid the price.
How did this happen?
As a debt markets banker for over 40 years, and a regional chair of the International Capital Market Association, I have recently been asked by many financiers from the international community how things went so very wrong and in London of all places.
At its simplest, the government thought it knew better than the market. It was wrong.
In a free market economy, who really has the upper hand — political masters or market masters?
Any economy that relies in part on debt markets (particularly internationally held debt) creates stakeholders who also have a say in the stable running of the economy. This is another of the lessons of the more recent sovereign debt crisis of 2010.
We are all surprised by the scale of the overall market disruption 30 years ago. Technology had sneaked up, allowing execution in size and at unimagined speed, turbo-charged by a burgeoning derivatives market. Markets had developed an extraordinary ability to overwhelm the central banks, an ability which is even greater today. By 1992, markets had evolved to a point where they were ready for a seminal showdown. The political class had believed it could hold the line. The rest is history.
Foolish bet
Fast-forward to today: despite the City of London’s extraordinary concentration of market knowledge, experience and understanding, the UK’s September-to-October government made a bet without checking the odds, and the market duly reacted. Most in the City would have advised caution.
This very British budget bust-up is perhaps another part of Brexit’s legacy of distrust and dismissal of experts who don’t pander to the political dogma of the day, a sign of overly optimistic belief in political power, or of the fallacy of British exceptionalism. Whatever the curious mix of influences, Westminster went its way and the City looked on as the market took its course. We are all chastened and made poorer by the experience.
Of course, the picture is inevitably a little more complex than that. As some observers note, it was not so much the essence of the mini-Budget plan, but its context, magnitude and timing that was the problem. A further complication that was not fully understood was the leverage within the pension system that pushed several funds to the brink of insolvency as liquidity and prices in gilts crashed.
The pension debacle recalls yet another lesson of another crash. Today, we are reminded that a lot of risk identified in 2008 has not disappeared, but has just been shuffled from banks to elsewhere in the financial system. The travails of the pension funds should serve as a wake-up call — there are financial risks still hidden in plain sight, a point well made in a recent speech by Sarah Breeden, the BoE’s director of financial stability.
An optimist will now hope that the new UK government will rebuild bonds of trust with experts and re-establish frayed lines of communication with the City and its institutions. Understanding the sheer power and speed of free markets, and the interests of market stakeholders, is all part of managing a modern and open economy. Another generation of politicians has learned an old lesson.
Tim Skeet is a career banker in the City of London. The opinions expressed are his own.
