Markets didn’t oust Truss, the Bank of England did

Liz Truss

The precipitous fall of former UK Prime Minister Liz Truss’s government has been widely credited to the objective discipline of financial markets. Her misguided policies, the logic goes, elicited such a negative reaction that she had no choice but to backtrack and resign.

I see a very different story. Markets didn’t oust Truss, the Bank of England did — through poor financial regulation and highly subjective crisis management.

Truss won the leadership of the Conservative Party, which the UK electorate had voted into power, by promising a range of deep tax cuts and government spending increases. Whatever one might think of her policies, they were her mandate. I agree with the many observers who expected them to lead to higher inflation, higher interest rates and quite possibly higher unemployment. But such adverse outcomes take months and years to play out. Her government fell in a matter of weeks. How could this happen?

The common wisdom is that financial markets “punished” Truss’s government for its fiscal profligacy. But the chastisement was far from universal. Over the three days starting Sept. 23, when the Truss government announced its mini-budget, the pound fell by 2.2% relative to the euro, and the FTSE 100 stock index declined by 2.2% — notable movements, but hardly enough to bring a government to its knees.

The big change came in the price of 30-year UK government bonds, also known as gilts, which experienced a shocking 23% drop. Most of this decline had nothing to do with rational investors revising their beliefs about the UK’s long-run prospects. Rather, it stemmed from financial regulators’ failure to limit leverage in UK pension funds.

These funds had bought long-term gilts with borrowed money and entered derivative contracts to the same effect — positions that generated huge collateral demands when prices fell and yields rose. To raise the necessary cash, they had to sell more gilts, creating a doom loop in which declining prices and forced selling compounded one another.

The Bank of England, as the entity responsible for overseeing the financial system, bears at least part of the blame for this catastrophe. As a result of its regulatory failure, it was forced into an emergency intervention, buying gilts to put a floor on prices. But it refused to extend its support beyond Oct. 14 — even though its purchases of long-term government bonds were fully indemnified by the Treasury. It’s hard to see how that decision aligned with the central bank’s financial-stability mandate, and easy to see how it contributed to the government’s demise.

The way the Truss government collapsed should concern all who support democracy. The prime minister was seeking to fulfill her campaign promises. She was thwarted not by markets, but by a hole in financial regulation — a hole that the Bank of England proved strangely unwilling to plug.