The Truss in the Coal Mine

Ex-Prime Minister Liz Truss has taken it on the chin. Mocked by the U.K. tabloid, the Daily Star newspaper, as unable to outlast lettuce, she proved to be the U.K.’s shortest-serving P.M. The scorn crossed the pond to the New York Times featured columnist Maureen Dowd. She dumped on Truss because “She didn’t understand that you couldn’t simply borrow money from the future.” This a strange observation from someone living in a nation with $31 trillion in debt. I’ve always found Dowd more snark than depth, and she continues to prove me right.

Nevertheless, Dowd is symbolic of the elite class here and abroad, claiming awareness of how debt and interest work but having no clue. I fear they’re going to find what their hubris has wrought.

While so many are having a great time over Liz’s political demise, we need to heed the message it delivers. While Truss’s fiscal plan is radical to some, it mostly follows the route taken by Margaret Thatcher and Ronald Reagan. Reducing stifling taxes and regulations to increase goods and services to offset too much money chasing not enough goods worked for those successful leaders. 

Truss opened the nation to fracking and new leases for offshore exploration to increase domestic oil and gas. She also reduced regulations. The most expensive part was that her proposed subsidies offset the U.K.’s sky-high energy costs. The E.U. will pay a similar fortune to subsidize energy to avoid a crisis. The plan also included some tax cuts. What government could survive its people freezing through the winter? In response, markets reacted harshly to the nation’s bonds and currency. The turmoil forced the Bank of England to intervene.

With only limited political support and an astonishing lack of grit and skill, Truss crumbled. 

Deregulation entails no cash outlays. Oil and Gas leases increase revenue in both the short and longer term. Coupled with proper Tax cuts, these can spur investment leading to faster growth. In the past, similar programs afforded creditors greater security, not less. So why the drastic market response?

The truth is the gilts (Government Bonds), and the pound was already in trouble. Significant U.K. pension funds received margin calls forcing the sale of gobs of Gilts, destabilizing the market for U.K. debt and currency. This situation compelled the Bank of England to step in and buy up gilts. Into this market climate, Truss introduced her program. She never stood a chance.

Pension funds getting margin calls; how could this possibly happen? Isn’t the use of margin ( borrowed funds) risky business? Of course. While enhancing returns when you’re right, losses mount fast when you’re wrong. Why would plans with fiduciary obligations get involved with such a precarious program?

In 2016, I wrote a post, ” Free Capital to Finance “More,” for my series on “More.” It attempted to explain how Central Banks forcing abnormally low-interest rates compels people and institutions into risky positions. Instead of salting capital away in safe but slow-growth investments, such as C.D.s and top-notch bonds, decent returns are available only in more dangerous things, such as stocks and real estate. The theory among the central bankers is this somehow leads to faster growth.

In the “More” post, ‘Simple Interest,” I expound on this further, pointing out the dangers of rising interest rates on unbalanced investors. The benefits of the leverage of borrowed funds can become a rapidly growing burden.

Rich country central banks had the power to keep interest rates low, or so people in control thought. Not even the part low-interest rates played in the 2008 Great Recession made these elites acknowledge the dangers.

The opposite is true. The low-interest rates encouraged governments to feel they could meet any problem simply by borrowing money. They forgot they engineered the low rates. Having the world’s reserve currency meant we could never default, so our debt is always salable. In the U.S., this was called Modern Monetary Theory (MMT). While not as widely used as reserve currencies, the E.U. and other wealthier countries operated similarly.

When covid struck, wealthier nations, including the U.S., turned to extreme lockdowns with vast subsidies. Poorer countries and prior in-place pandemic planning never contemplated shutting down economies simply because it would be ruinous. Only countries believing they had unlimited credit had the hutzpah to lockdown. Convinced that they could jam on the brakes across the board without dire consequences, they sent out waves of checks to people producing little or nothing. 

Lots of money in people’s pockets while producing few goods as we came out of the lockdowns; what could go wrong? Economies needed much more energy to power the recoveries. Affecting almost everything we do, power at a reasonable price is essential to stability. We needed more, but a war on fossil fuels meant we got less. People needed to return to work to produce goods and services, but many were still collecting government checks. We passed a $2 trillion bill continuing to pay people to stay home while inhibiting the production of fossil fuels. All this is on top of already unstable finances.

 In the 1970s, we found once the inflationary genie is out of the bottle, it feeds on itself. Prices of almost everything rose—all that money chasing the low supply of goods and services. Only by restricting demand with punishing interest rates while adopting policies to increase supply were we able to extinguish the fire.

With little action to increase supply, it falls to rising interest rates to fight inflation. As I predicted, this will knock the unbalanced to the floor.

Defined benefit retirement plans are prevalent in the U.K. These plans have to pay out a specific amount no matter what. This situation explains the dire straits U.K. pension funds find themselves in. With safe interest rates earning at best 1% and obligations needing returns above 5%, they had no choice but to find a way to up returns.

So long as interest rates were meager, the plans seemed solvent, using lots of short-term money to buy lots of longer-term higher-yielding gilts. Once they started up, the heavy leverage using sophisticated derivatives offered by the “smart” people fell apart. The gilts they put up as collateral lost value. Who wants a 1% long-term Bond in a 4% world? Lenders demanded more backing, the dreaded margin call. They had no choice but to sell, forcing the Bank of England to step in and buy.

As interest rates continue their upward march, how many more of the unbalanced will face a similar crisis? We don’t know, but they’re out there because low-interest rates forced them to take abnormal risks. 

Late Friday, Japan had to support the Yen. If you think the Bank of England’s intervention was a one-off, think again. Who’s next?

The real message of Liz Truss’s humiliation is bad interest rate policies by those who should’ve known better have left little or no room to maneuver. The markets seeing so much debt won’t allow the time needed to implement supply-increasing policies before the calamity. Those who favored the super low-interest policies bringing us to this point might refrain from dissing Truss and instead take her fate as a harbinger of things to come.

Remember Murphy’s Law, ” What can go wrong will go wrong sometime.” Increasingly now looks like the moment. It will be interesting to see which leaders join Liz Truss in the hall of the humbled.

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