Trump’s Budget has similarities with Truss’s – will his fate be the same?
This article is by Mark E Thomas and Vincent Gomez of the 99% Organisation, a former investment banker and member of the Bank of England’s Citizens’ Forum.
Liz Truss was UK Prime Minister from 6 September-25 October 2022. At 50 days, this is the shortest prime ministerial tenure in history. Her departure was prompted following her ‘mini-budget’ on 23 September, and its reception by her party, the financial markets, the IMF and the press. Their reaction was so negative that after just over one month in office, she removed her Chancellor, Kwasi Kwarteng, and reversed most of the economic policies in the mini-budget. The Economist magazine wrote that in just seven working days in power, she had managed to cause enormous economic turmoil and compared that period to the shelf-life of a lettuce. The British newspaper, The Star then set up a livestream with the title “LIVE: Can Liz Truss outlast a lettuce?” When Truss announced her resignation on 20 October, the lettuce was still going strong.
There are strong parallels with Trump’s 2025 budget which also, in its determination to slash taxes, will cause a significant increase in the deficit and, over time, in the ratio of government debt:GDP. The Financial Times has been wondering since April, “Has America discovered its ‘moron risk premium’?” (That phrase had been coined in reference to the fall in value of both bonds and currency that Britain experienced after Truss’s mini-budget).
With Trump’s Budget about to pass into law, this is a good time to ask: Will the orange go the way of the lettuce?
Maybe, but not if Trump uses US institutions to his benefit:
- There is an accepted story about Truss’s downfall which most media and policy-makers seem to subscribe to;
- The true story is about failure to understand and work with the UK’s institutions;
- Trump will fall flat only if he fights the Fed.
There are important lessons here for the UK government.
The accepted story of Truss’s downfall
The accepted story is simple: Truss ignored the advice she received from HM Treasury (she sacked the Permanent Secretary at the Treasury), ignored the OBR and the Bank of England and proceeded to borrow too much. The credibility of the UK as a borrower was damaged by this and UK bond ratings fell; the markets moved against both bonds and sterling – and an inevitable crisis ensued. As the outgoing head of the Debt Management Office told the FT “British politicians should be wary of provoking a backlash in financial markets by increasing borrowing too quickly.”
The dynamics implied by this story are captured in the picture below.
In this model, any deficit would have to be funded by borrowing. Borrowing would, if large, increase the debt:GDP ratio. That ratio would influence the bond-rating agencies. And when the agencies reduced their ratings, the bond market would react accordingly and borrowing costs would rise, further fuelling the deficit and creating problems of sustainability.
This is clear, simple and wrong.
The true story is about the UK’s institutions
If the story above were true, we would see it in the data. We would see that when borrowing rises, bond ratings decline and the cost of borrowing rises. We would see that a very rapid increase in debt causes an immediate crisis. We would see that if British politicians borrow too quickly, they are punished by the markets.
Instead, this is what we see.
The red line is the ratio of Debt:GDP – the thing which is supposed to drive the market reaction. It starts to rise sharply after the Global Financial Crisis, so we should expect to see the blue line (the interest rate demanded by the market for holding government bonds) rise with it. We do not see that: we see it fall. Even when the bond rating agencies started to reduce the UK’s rating from triple-A to lower levels, we saw the yield continue to fall.
And in 2020, when Debt:GDP was already at around 80 per cent and the government suddenly found that it needed to find an additional £70 billion to fund the COVID furlough scheme – money it had previously said it did not have – and debt shot up to over 100% (surely, that would be “too quickly”?), bond rates still did not rise. This is because the government made good use of its institutions – the UK became the first country in the world to use direct monetary financing to pay for the spending. In this case, the Treasury instructed the Bank of England to create the money, and the Debt Management Office turned it into bonds which the BoE then purchased directly without the necessity of troubling the markets at all.
But when Truss launched her Budget, without getting the institutions on board, we were in an inflationary environment, caused principally by the energy price rises after Russia invaded Ukraine. The BoE had already started to raise interest rates. And so when Truss’s inflationary budget came out, with no institutional support, we finally saw a rapid rise in bond rates. After just a few days, this began to cause dangerous problems in the pensions industry where, as the FT reported, “pensions had to sell gilts because gilts are easy to sell. … They needed to raise cash. What did they need the cash for? Well, the cruel irony is that pensions needed collateral for margin calls on leveraged trades hedging against big moves in . . . UK government bond yields.” A vicious circle had been created, and the Bank of England stepped-in. At that point, bond rates fell sharply, and with the BoE now backing gilts, and a reversal of the Budget provisions, the problems started to subside. The lack of BoE backing, not the borrowing, was the fatal flaw in Truss’s approach.
It is impossible to square the accepted story with the data.
Trump will fall flat only if he fights the Fed
The data from the US shows a similar picture.
For the two decades between 2000 and 2020, the debt rose steadily from under 60 per cent to over 100 per cent and the reaction to all this extra borrowing was that the bond rating remained triple-A and bond rates fell. Precisely the opposite of the reaction the accepted story would predict.
Trump is now facing the same kind of criticism that Truss faced – and much of it is justified: his budget has been described as the largest upwards transfer of wealth in US history. But the idea that it will face the fate of Truss’s budget is – as it was in the UK – all to do with the institutional response.
In the US, the received wisdom has long been that the bond markets are the 800lb gorilla. Clinton’s political strategist James Carville joked that if he could be reincarnated, he would come back as the bond market because “you can intimidate everyone.”
But bond traders themselves know who is really the biggest gorilla. They say, “Don’t fight the Fed.” Whereas the banks and shadow banks who might bet against US bonds have enormous capital to deploy, the Federal Reserve (“the Fed”), the US equivalent of the Bank of England or the European Central Bank, has unlimited firepower. If the Fed wants to keep interest rates low, it can.
If Trump has the Fed on board he will not fall flat like Truss, though he will fail his countrymen and women; if he does not, the orange could go the way of the lettuce.
Conclusion
The UK government appears to believe the conventional story of Liz Truss’s downfall – which means that it runs the risks of making the same mistakes…or worse.
We wrote before about how, if the government were seriously to attempt national renewal without rewiring key institutions, it could find itself hitting a Truss-like problem.
Even worse would be to accept that it cannot seriously attempt national renewal, and simply hope for the best. That kind of learned helplessness would be an even bigger disaster for the UK.
If you would like to be sure your Labour MP is thinking hard about this, tag them into this article and share it widely on social media. Or write to them. This website makes it easy: https://www.writetothem.com/, though a handwritten letter or personal email has the most impact as the effort is recognised!
And take a look at the 99% organisation and join us.
