16 September 2022

The UK’s ‘Virtuous Sovereign Trinity’ is in real danger


London this week has been extraordinary, as hundreds of thousands queue for hours on end to pay their respects to the late Queen. Affection for Her Majesty and hope for King Charles have given the whole nation a sense of quiet dignity that has been lacking over the turbulent years of Cameron’s confabulations, May’s mayhem, and Boris’ buffoonery.

Unfortunately, dignity and waving flags do not pay the bills. When the pageantry is over, we need to face up to the fact that genteel national poverty could be around the corner. Boris may be gone, but the Government is still lolloping around like a mattress in a swamp, with massive implications for the economy.

It’s all about confidence and communication.

When markets lose confidence in a nation, bad things happen can happen fast. The ‘Virtuous Sovereign Trinity’ model describes how a nation with a well-run political economy (effective politics and a functional economy), a stable currency and a strong, efficient bond market will likely succeed in multiple ways. These include attracting inward investment, fostering strong labour/management outcomes to drive productivity, wealth creation, and avoiding inflation.

Get it wrong, however, and things can explode.

That brings us to the collapse in value of sterling. Despite what some might claim, the tumbling exchange rate is not just a function of the dollar’s strength but also of genuine concern about the direction the UK is going. To make matters worse, a weakening pound fuels inflation, which is why the UK is expected to underperform its European peers.

Doubts about our trajectory are further fuelled by rising industrial tension, as workers demand pay rises – both in response to immediate price rises and to many years of widening income equality, during which wages have barely increased but house prices have rocketed. The brutal truth is that we are ill-prepared for the consequences of higher interest rates – be it on consumer debt, the housing market (the traditional economic gold standard) and commerce.

The public finances are also a cause of grave concern, especially as the recent rise in gilt yields raises doubts about what the Government will have to pay to finance all its spending.

With all that in mind, it’s not clear the new government has a carefully considered plan to to restore the public finances and put the country back on the path to prosperity. And though Liz Truss won the leadership handily, she will be acutely aware that she didn’t have the backing of most of her parliamentary colleagues and that, lest we forget, she is the fourth Tory PM since 2010. Bear in mind too that, in a time where clear messaging is so vital, she is far from the most natural of communicators.

Now, we should give Truss and her Chancellor Kwasi Kwarteng credit for the broad-brush policies announced so far. Foremost is, of course, the energy cap freeze – a promise to protect the economy from the effects of the Ukraine energy shock. Businesses will be offered ‘equivalent support’ for six months and ongoing support for vulnerable industries which will, apparently, include pubs. A new round on oil and gas licences will be announced, as well as removing the ban on fracking. We will get a new nuclear power outline that will generate 24 GW by 2050.

These are all reasonable enough policies, but for now they are just words and the devil with these things is always in the detail. We will get details on how it will work after parliament reopens in October, including how energy bills at an average price of £2,500 will be frozen. Reports suggest it may be November before businesses start to see money come in to cover their huge cost increases. We still have no real idea what the Treasury analysts believe the likely sums required to support industry and consumers will be.

There’s a political issue too in that freezing the energy cap is blindingly regressive. It does little to help the millions of households currently in fuel poverty, but offers a sop to middle class voters who will certainly be inconvenienced, but could have afforded a hike in their bills nonetheless.

There were other less regressive and less expensive ways to address the crisis – windfall taxes, progressive energy subsidies forcing the rich to pay more and consume less and schemes to limit energy to each household, meaning the rich would pay more to consume more. All of these have their own flaws and raise problematical consequences, but each is probably better than the simple, ‘don’t worry, we can fund it all through borrowing’. There’s only so far the can be kicked down the road before the consequences catch up with us.

GIlt complex

Confidence in the gilt market is particularly critical given the amount of extra borrowing we’re looking at. If the gilt market melts down and rates rise, then the Virtuous Sovereign Trinity will tumble with it. We can’t pretend the kind of fiscal loosening Truss and Kwarteng have slated will somehow be consequence-free.

But there has not yet been any guidance on how the UK’s Debt Management Office (DMO) should factor a sudden, massively increased funding requirement into its carefully planned gilt issuance strategy. The DMO is one of the UK’s greatest financial secret assets – running a very effective UK’s government gilt issuance market. It might not make the headlines often, but a properly functioning government bond market is a prerequisite to a strong economy.

It is no exaggeration to say the UK faces a fundamental crisis in terms of its Virtuous Sovereign Trinity – a potential collapse in the bond market, further weakening in sterling, and a failure by the Government to address the multiple crises facing the nation can only make things much, much worse. So far main response has been to get rid of the Permanent Secretary at the Treasury, Tom Scholar – one of the few people who truly understands the system and could have helped navigate this extremely turbulent period.

Nor can the Tories wave their hands and blame Labour for the state of the economy. They have been in power for 12 years and face a huge challenge to craft a fresh, compelling narrative for the next election, due some time before December 2024. A focus on growth, cutting red tape, reducing government inefficiency and ‘making Brexit work’ are all liable to feature – but it will be impossible to sustain the idea that the Conservatives are prudent trustees of the public finances if the economy has nose-dived.

By the same token, insisting to voters that Labour would be a disaster for the economy holds a lot less water if things have gone terribly wrong on your own watch. Nor is the claim that Labour governments always botch the economy necessarily true: governments of both parties have presided over booms and busts, but the past 12 years have seen something more insidious: a long, stolid period of anaemic growth, piddling productivity gains, low business investment, and widening inequality, including in health outcomes.

So beware breezy blandishments about supply-side reform and ‘going for growth’ – the scale of the challenges facing Truss and Kwarteng is enormous, and they don’t have much time to start putting things right.

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Bill Blain is market strategist and head of alternative assets at Shard Capital.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.