The British Political Psychodrama – and Why the World is Watching

Trussonomics RIP

When I warned readers back in March last year that a tsunami of inflation was about to hit the UK, I observed that weak governments cannot survive a sustained bout of rampant inflation – it is just too corrosive at every level of society. If workers with strong bargaining power can exert pressure (through strikes) to earn real-terms wage adjustments, then inflation is just sustained longer. And if they don’t, then living standards fall rapidly – an occurrence which generates political risk as democratically elected governments become increasingly unpopular.

Most people now feel worse off than they did at the time of the last election just under three years ago. The price of basic foodstuffs like pasta, vegetable oil and dairy products has risen faster than the price of higher-end produce: so, as usual, the least well-off are hit hardest – which prompts calls for additional welfare measures. (I argued here in the summer for free school meals for all children – and Jamie Oliver agrees). Furthermore, people suspect that, at this rate, they will feel even worse off one year from now.

In the momentous year of 1974, the last time that double-digit inflation prevailed across the West, nearly every government in Europe and North America fell. Admittedly, however, Richard Nixon resigned as president of the US because of the Watergate scandal and the president of France, Georges Pompidou, died in office.

The UK had two general elections that year. The first produced a minority Labour government (Labour got just 301seats) and the second a Labour government with a wafer-thin majority of three seats. Inflation finally peaked in August 1975 at 26.8 percent. The top rate of income tax then was 83 percent and there were taxes on unearned income.

In the face of twin economic and geopolitical crises, the UK Conservative party – like other parties − has had a vigorous debate about the future course of economic policy. Initially, the ‘Trussites’ won out with a ‘Reaganite’ programme of tax cuts funded by borrowing to stimulate growth. But the measures advanced in Kwasi Kwarteng’s mini budget of 23 September were presented naively, like a child’s letter to Santa, with no substantial economic plan behind them. The markets wobbled and fair-weather Tory backbenchers panicked. The wheels fell off the ‘Trussmobile’ − and the Sunak ‘machine’ swung into lethal action.

Rishi Sunak warned the country as he entered Downing Street that it faces “a profound economic crisis”. While we can be sure that his economic policy will be based on meticulous spreadsheets, we don’t yet know how much “austerity” he will determine is necessary. We’ll have a much better idea after Jeremy Hunt’s autumn statement (which is not a mere “fiscal event”), now scheduled for 17 November. Sunak understands, however, as did Margaret Thatcher, that supply-side reforms to the economy cannot be achieved during a period of rampant inflation. The number-one priority, therefore, is inflation. As the new prime minister said on Wednesday, inflation is “the enemy”.

But inflation is an international phenomenon in this case and will only be alleviated when we adapt to higher hydrocarbon and food prices during a period which coincides with the end of cheap money. No politician is going to tell the people that the good times are over and that they need to get used to a more frugal age – even if he or she believed that to be true. But that is the reality.

The fact that Sunak retained Hunt – Liz Truss’s second chancellor – demonstrates that the second-order priority is to calm the markets. I predict that there will be tensions between these two pillars of the new government, for reasons that I shall explore in detail soon. In brief: they are both ‘Davos Men’, but Hunt is much more in favour of a closer accommodation with Europe − and that is going to be the major issue of the mid-2020s.

Of course, it was amusing for a German newspaper to depict Big Ben as a giant banana. In India, The Hindu Times, called the drama in the UK “a cautionary tale for how bad politics can lead to even worse economics.” China’s Global Times described the UK as “a joke”. But, in time, the joke may not be entirely on us. The UK is the first leading country to experience an inflation-induced ‘psychodrama’ – but it will not be the last. The American commentator Joseph C Sternberg wrote in the Wall Street Journal on Monday (24 October):

“As fun as it might be for outsiders to gawk at the political chaos engulfing the U.K., Prime Minister Liz Truss’s resignation Thursday is a sideshow. The bigger problem is that recent events in Britain are an alarming vision of a fate that potentially awaits all of us in developed economies.”

The Davos acolytes have been watching uneasily because the UK has been the ‘canary in the coal mine’ – and why that is should be better understood.

Crises are contagious

Financial crises, particularly when driven by sudden waves of inflation, inevitably cause regime change. And curiously, historically, financial crises most often take place in the autumn.

In September 1931, Britain abandoned the gold standard. The US followed in 1933. The devaluation of sterling in September 1949 ended post-war hopes of a multilateral currency system and confirmed the hegemony of the US dollar. Harold Wilson’s second devaluation of sterling in November 1967 started a chain reaction that culminated in the ‘Nixon Shock’ of 1971. That entailed the abandonment of the Bretton Woods (1944) monetary system under which the dollar was pegged to gold at a price of $35 per ounce.

Denis Healey’s International Money Fund (IMF) bailout in September 1976 discredited Keynesian policies and ultimately led to the election of Thatcher in May 1979, inspiring the monetarist revolution later pursued by Paul Volcker as chairman of the Federal Reserve (Fed) and president Ronald Reagan. The breakup of the European exchange rate mechanism (ERM) in September 1992 forced France, Italy, Spain and Greece to accept Germany’s economic dominance in Europe – and ultimately led to a German-led single European currency.

The bank run against the UK’s most aggressive mortgage lender, Northern Rock, in September 2007, anticipated the global financial crisis one year later. Bear Stearns went down in March 2008 and Lehman Brothers in September 2008, with its extraordinary and devastating consequences. At the time, the Europeans dismissed Northern Rock as a uniquely British fiasco, yet within a year the Eurozone was embroiled in the European sovereign-debt crisis which nearly brought the single currency to an unceremonious end.

Governments that experience devastating financial crises almost always face electoral oblivion. After the UK’s ejection from the ERM on “Black Wednesday” (16 September 1992), the Conservative government led by John Major aimed to restore the British economy to robust good health – but that did not stop it from being annihilated by Tony Blair’s New Labour in the May 1997 general election. The British economy might well look healthier in the autumn of 2024 than it does now – but that may not save the Tories. It is extraordinary that Kwarteng − a man with a doctorate in economic history – did not heed the lessons of the past.

Further to the gilts-market wobble in the week of 26 September, other countries are asking if the “bond market vigilantes” will make a comeback. That is most likely to happen in the US. For the Fed, president Joe Biden and US public opinion, the painful choice is between accepting years of above-target inflation or implementing a macroeconomic policy that precipitates recession.

The whole of the developed world has stepped into a new economic paradigm: the age of near-free money, cheap energy and cheap food is over, and that will have huge medium-term consequences for living standards. It is unlikely that Sunak’s famous wizardry with spreadsheets will be able to reverse that trend.

One major reason for the dire state of UK public finances to which the new prime minister referred on his first day in office was that – under his financial leadership – the state paid people to stay at home for nearly two years during the coronavirus pandemic. The taxpayer funded a host of initiatives, some heroic (the vaccination programme), some lame (Test and Trace, Eat Out to Help Out and Covid business loans), which collectively cost about £400bn (all borrowed).

This came after a decade of money-printing by the central bank. Then, Truss and her team determined that the UK government should massively subsidise the gas bills of all and sundry – so that the poor could keep warm and the rich could continue to heat their swimming pools 24/7. The then prime minister and her team did this without encouraging people to consume power more efficiently, even in the mildest autumn ever recorded.

On Thursday (27 October) the European Central Bank raised rates in the Eurozone by 75 basis points. The Bank of England is likely to move in similar fashion next week on 3 November. Rising rates will be the recurring theme – the Wagnerianleitmotif – of the Sunak premiership.

The Brexit factor

The UK is “doomed” and on a path to becoming once again “the sick man of Europe” because of the way Brexit was negotiated, according to Guy Hands, the founder and chief executive of private-equity firm Terra Firma Capital Partners. Hands, who has been a donor to the Tory party, is a critic of Brexit. He warned on BBC Radio 4’s Today programme on Monday that the UK faces higher taxes, lower benefits and, ultimately, a possible IMF bailout. He said:

“I think [the Conservative Party has] got to move on from fighting its own internal wars and actually focus on what needs to be done in the economy and admitting some of the mistakes they’ve made in the last six years which have frankly put this country on a path to be the sick man of Europe.”

Hands added that the party was, in his view, not fit to run the country. He said that Brexiteers had a dream of a low-tax, low-benefit economy, but that this “clearly isn’t something that’s acceptable to the British people”. He also made this comment:

“Once you accept that you can’t actually do that, then the Brexit that was done was completely hopeless and will only drive Britain into a disastrous economic state…I think if the Tory party can own up to the mistake in how they negotiated Brexit and have somebody leading it that actually has the intellectual capability and the authority to [re-]negotiate Brexit, there is a possibility of turning around the economy, but without that the economy is frankly doomed…”.

I cannot speak for Hands, but I think his point was about the impact of Brexit on the national finances. He, like many others, thinks that Brexit has restrained the upside growth potential of the British economy.

There are only three ways to avoid a debt spiral: raise taxes; cut spending; or boost growth. Without a return to the long-term trend growth rate exhibited over the period 1945-2010, of about 2.7 percent, the UK national debt will only move upwards without a contraction in the welfare state – which is, effectively, politically impossible. The endpoint of that is national bankruptcy and an IMF bailout, with all the humiliation that would ensue.

I predict that the dominant issue by the time of the next election two years from now will revolve around how best to restore cooperation with the UK’s dominant trading partner − the EU. The Labour party will not commit to reversing Brexit, but it might well propose that we rejoin the customs union or at least negotiate a new customs union. That would involve aligning regulations with the EU single market – so expect Labour to oppose any attempt by the Tory government to junk EU regulations (something it has conspicuously failed to do thus far).

If Labour were to espouse moving towards a closer relationship with the EU, modelled on Switzerland and Norway but with specifically British characteristics, I think that that would prove an electoral asset in 2024. The war in Ukraine has set a new tone in UK-EU relations: both sides have realised how much their security interests are aligned. And if Labour promise to privatise the power and water utilities too, they will attract support. (Even many Tory voters subscribe to that). Even recently, such policies would have looked high-risk; but British politics has changed fundamentally in the last two months.

Young people don’t understand why freedom of movement (the right to live and work in Europe without restriction) has been taken away – nor do some more mature citizens with family in France as I have. Small businesses have given up trying to export to Europe – it’s just not worth the hassle. Over time, the perception that Brexit was an error will grow.

The Tories’ unfinished civil war over Brexit might yet reignite under Sunak’s watch. Steve Baker MP, chair of the European Research Group, has warned that the Tory eurosceptics will “implode the government” if it does not instigate promised changes to the Northern Ireland protocol. Tories of a Remainer inclination will argue that the only way to solve the Northern Ireland trade issue is to rejoin the single market.

Brexit will reanimate, like the ghost of Banquo at the feast.

Market reaction

Since Sunak took the reins of government, sterling has been trading above $1.15 and the yield on 10-year gilts has fallen significantly. This morning the 10-year gilt is yielding 3.439 percent, having nudged five percent in the week after the mini budget. So, we are almost back to the financial landscape that prevailed during the later period of the Johnson government. The yield on the 10-year gilt was just over one percent a year ago, so borrowing costs have prospectively risen threefold. And the UK fiscal deficit could hit £200bn by the end of this financial year.

The bond yields of different governments do not reflect relative default risk because their bonds are denominated in different currencies (except in the Eurozone where bond spreads relative to German bunds tell an interesting story). In order to determine how the bond market calibrates relative default risk, we need to look at the market for credit default swaps (CDSs). CDSs in respect of UK gilts fell to 33.92 basis points, compared with 34.25 on Monday for French government bonds. That means that the market thinks that France, which seems poised to enter recession, is a worse bet than the UK. CDS rates for Belgium have risen to 48, to 66 for Spain and Portugal and to 195 for Greece.

France is enduring a wave of industrial disruption by unionised labour. Emmanuel Macron’s political party does not have a majority in the National Assembly and his government had to push through the budget last week by presidential decree, to the fury of the opposition, which tabled no-confidence motions. Macron’s government just survived.

Italy, where a right-wing, eurosceptic government has just taken power, faces a winter of recession and gas shortages. The Germans are worried about the end of cheap energy – their mercantilist export-driven model is now under threat. Hungary (where inflation is running at 20 percent) and Poland both face fiscal crises which they blame on the EC for refusing to release coronavirus recovery funds. France, Italy, Spain and others are highly vulnerable to upward pressure on rates in the Eurozone. I shall have more to say about that shortly.

Far from being a joke as China’s Global Times opines, the British political system has been working successfully at a time of extreme national and international stress – even if we have had four chancellors so far this year (not to mention five education secretaries).

A long-reigning monarch has been succeeded by her heir. A high-risk and unsuitable prime minister elected by an unqualified party membership (as was the disastrous Jeremy Corbyn elected by Labour) was swiftly replaced. The Tory party has been the longest-functioning political party in any western democracy over the last two hundred years and more. This week it showed it is alive – and still kicking.

I note that Prime Minister’s Questions on Wednesday (26 October) had an unexpectedly jovial atmosphere, although not in any ‘boosterish’, Johnsonian sense. The energy was more positive and constructive. There was joshing, but this was largely courteous. There are reasons to suppose that Sunak’s government may not succeed – we don’t even know what the criteria for success are yet. The real question is how long the recession will last (even if it is an unusual one without mass unemployment) – which is also to ask how long the war in Ukraine will last. Uncertainty prevails.

But let’s hope that the quality of the national discourse improves in the meantime.