ALTIF Transcripts: The Kami-Kwasi Budget

Jonathan Ford 00:06

Hello and welcome to a long time in finance with Jonathan Ford and Neil Collins, in partnership with briefcase dot news, the service that brings intelligent curation and analysis to your media monitoring.

Kwasi Kwarteng (Extract) 00:21

Mr. Speaker, we are at the beginning of a new era. And as we contemplate, and as we contemplate this new era, we recognise, Mr. Speaker that there is huge potential in our country. We have an unbounded entrepreneurial drive, we have highly skilled people. We have immense global presence in sectors like finance, life sciences, technology, and clean energy. But Mr. Speaker, there are too many barriers, for enterprise, we need a new approach to break them down. And that means reforming the supply side of our economy.

Jonathan Ford 00:56

So in the days since Kwasi Kwarteng, the chancellor, announced a new era for the UK economy, it’s come to seem more like a new error. In his statement, the chancellor focused on cutting taxes, claiming this would improve the UK’s anaemic growth, and added some 45 billion pounds to borrowing on top of the 150 billion already required to fund the government’s energy price scheme. He did promise some other supply-side measures (details to follow later), along with the details of the government’s new fiscal rules explaining how all this new debt would be paid off on top of the mountain we already have. The statement certainly got a reaction, if not wholly the one he was hoping for. The markets crashed the pound and forced up government bond yields to a point where the Bank of England was obliged to buy guilds to head off a possible financial crisis centred on the pensions industry, it’s really hard to think of a budget which has attracted such an enormous raspberry. So we thought we’d ask how Howard Davies is former Treasury official financial regulator, head of the London School of Economics, and chairman of NatWest, and also author of the Chancellor’s; a new book about the Treasury and its political masters from 1997 to 2021. So welcome, Howard. I suppose where we should get started by asking you really how do you rate this budget in terms of its reception? It? Is it the worst you can think of?

Howard Davies 02:20

Well, it wasn’t a budget, it was a special military action, a special fiscal action, rather than a budget. And I think what it shows you is that the market is now conditioned to expect that when a Chancellor’s makes a big fiscal announcement, that you will get both sides of the balance sheet, and that you will get some revenue numbers as well. And you get spending numbers as well, so that you can see both sides of it. And also that they expect now since George Osborne introduced it, that the Office of Budget Responsibility will have it say, and if you do that now in the wrong way – in other words, without letting the OBR give a view, and only giving the taxing side, then it seems that the market doesn’t like that anymore. So I don’t think you can easily compare this, because normally you do get both sides of the account. But as far as politics are concerned, I mean, the conventional wisdom is that every budget that’s well received on the day turns out to be a dog’s breakfast subsequently, and vice versa. But I think perhaps George Osborne’s famous, Omni Shambles budget, which is now most remembered for the pasty tax at Gregg’s was probably equally unpopular in political terms, and probably doesn’t look very good in retrospect. But I think the more important lesson rather than comparing the previous ones is that if you do depart now from the script that people are expecting, then people find it very difficult to know how to evaluate it, and the likelihood is you get the kind of unstable and messy reaction that we have this week.

Neil Collins 03:59

Do you not think it’s at least as much because of the size of the sums involved, and the amount of debt which would be required to deal with it rather than failing to get an analysis from the OBR.

Howard Davies 04:15

I’m not sure because after all, much of this, I mean, the big number, the energy price was pretty well trailed. I mean, I think everybody expected something along those lines. And the investors I think, adjusted their expectations, so that. I think what made people more nervous was the unscripted tax cuts, which were not the hugest part of the package, actually, but the 45 to 40 and the bankers’ bonuses, which obviously doesn’t make that much difference, but those things were a surprise. And what I heard people saying was, well, gosh, if they’re going to come out with that kind of thing, what else might that be? And so it was a nervousness created (inaudible) this might be followed with further tax cuts.

Jonathan Ford 05:00

We had a look back at budgets, really looking at the reception they received in terms of their impact on this, the sterling dollar rate. Which of course, crunched in this case. And it’s amazing. If you look back basically, even if you go back to Dennis Healy’s budget in 1976, which was a year that we went to the IMF, that was less than 1% reaction, how similarly about 1% in the 1981 budget, which was, of course, a tax raising budget, but all the worst reactions are the ones as you get closer to the present day. Osborne’s 2011 budget, Sunak’s 2020 budget, which was obviously accompanied by this pandemic, and the spending that was required to create the furlough scheme. And this, but this is … Sunak’s was minus 2.5%. This is minus 5%. It does convey an impression that the markets if you like, you’re getting a little bit twitchy here, about the increasing massive amounts of debt, which pile up and the sense in which there is not a real plan in place, particularly now under Kwarteng, because he’s yet to tell us as you say, what he’s going to do, there doesn’t seem to be a plan to credibly deal with it. And indeed, in your book, you point out that the number of fiscal rules that pop up all the time, seem to correlate with a general lack of credibility that anyone’s ever actually going to implement them.

Howard Davies 06:21

Yeah, that’s true. I mean, I have to say, looking back, I think I would discount anything before 1992. Because before then, the picture was quite confused, because of course, you did have the possibility, and the actuality in some cases, of Bank of England intervention in the exchange market. So we did have until 1992, we did have at times a managed exchange, to some degree anyway. So I think we probably got to look beyond 1992, you do have an environment. And to this extent, the Prime Minister’s responses, you know, have some weight. Of course, it is a very, very nervy environment. And if you look at what’s been going on, on the exchange rate, it’s been more $ strength story than a sterling weakness story. We’ve gone down pretty much alongside the Euro until the last two or three weeks. But I think what that told you was that, you know, you’re in a very, very nervy environment. And therefore, if you do anything that is unsettling, and doesn’t have any, any sort of revenue or spending cuts, et cetera, involved in it, then you know, you could get a pretty tough reaction, because the markets anyway looking for trouble if you like. And that’s, I think, what you’ve got, and of course, we’ve had to some extent, pounds come back in the last few days. But the volatility is enormously high at the moment, and that’s very unsettling. But I mean, I think what he tells you is, these were the lousiest circumstances in which to do anything experimental. And essentially, this was experimental – is let’s do the tax cuts first, and then follow with something on spending, which is an unusual way of doing things. And certainly, to act at a time when, you know, when everybody is very nervy anyway, was, I think, fraught with menace and, you know, the longer term confidence implications could be quite severe.

Jonathan Ford 08:10

What about the tonal aspect of it? You know, there was a lot of self-conscious sort of posturing almost as revolutionaries we’re going to come in and yes, kick the doors of the Treasury in getting rid obviously, of Tom Scholar, which some people thought was a unwise thing to do, I guess. The tone of the budget was very almost glib in its sort of presentation. Do you think that was a mistake?

Howard Davies 08:34

I mean, I think it was, it was deliberate. You know, I don’t think that this was just an accident. I think that they have a view that they should demonstrate that growth is the principal objective, that they are prepared then to do what might be regarded as politically difficult things in order to achieve it – to achieve a lower level of spending and taxing. There’s an element of you know, what the Republicans used to call ‘starve the beast’ of saying, Well, if we actually remove the revenues first, then people will appreciate that we have to cut spending, because the revenues aren’t there to fund it. You just make that commitment, and then you’ve sort of consequences follow. I think it was a deliberate strategy. And it seems that they plan to carry on with it. But the question mark, of course, is whether the party will buy the spending cuts that are needed in order to make the thing look balanced in the medium to long term.

Neil Collins 09:32

Do you think the UK economy is capable of growing two and a half percent? Seems to me extremely unlikely.

Howard Davies 09:40

Yes, the trend growth has been well below that certainly since 2008. It looks unlikely because reducing trade intensity – in trade would normally be; promote competitiveness and productivity growth, etc. So you’ve got reduced trading intensity, which is partly Brexit, but not by any means all, because you know, there is a reduction in trade in a number of places, because onshoring, friendshoring, whatever you might say, it’s very hard for me to see how you can get to a 2.5% growth rate. Now, of course, there are other things that government could do. I mean, you know, there are other things on planning, which is the most obvious one, which might cause economists to say, well, that gives you the opportunity for stronger growth, then the question is whether they can actually overcome what have typically been Conservative party objections, in many cases to significant relaxations of the planning regime. And that would probably give a boost to growth in the short to medium term. So, you know, there are some things that they could do, but I can’t quite see in the back of my envelope, how I get from where we are now to two and a half percent, except, you know, in the year you emerge from another recession – I mean, maybe you’ll get, you know, you’d get a year where the economy grew two and a half 3%, as it has done in the last year, of course – but at a sustainable growth rate of two and a half percent? It’s very difficult to see.

Jonathan Ford 11:07

Do you think the idea of shock therapy, if you like, this sort of shock tactics, is a valid one?

Howard Davies 11:14

It’s not absurd, but the difficulty is, who is the audience you are trying to influence, there might be people who are thinking of investing, typically, what they want is a more, you know, is a stable environment. And the kind of volatility that we’ve injected, is not very encouraging from an investment point of view. But there may be another audience, which, of course, is in Parliament, and in the Conservative Party itself, where you’re trying to convert the Conservative Party into a party, which is more growth-oriented than NIMBY-oriented. That’s a debate that the Conservative Party has been in the middle of, for quite some time. And it may be and I’m not so well placed to judge, I guess not of the three of us is really, as to how far you might shift the centre of gravity of the Conservative Party into being in favour of things which they have resisted before. And obviously things like fracking, which the Prime Minister’s making a lot of, or indeed, probably more significantly changes to the planning regime, which is a fence at which the Conservative filly has refused several times in the past. You know, will this create conditions in which she will jump it? But I suspect that might be quite a large part of the audience that the government is looking to influence at this point?

Jonathan Ford 12:34

Yeah. Can we talk a tiny bit about the reaction to the budget? And obviously, we’re recording this week after Kwasi made his statement. So yeah, just to set it in context. So think there may be things that come up before this gets broadcast, which we won’t know about. But looking back to what happened. I mean, I suppose the disturbing thing, if you look at it, in the eyes of a former regulator, is the way in which you see the reemergence of this sort of tail risk that we saw in the financial crisis, of volatility leading to vulnerabilities which people hadn’t necessarily thought very much about. I certainly hadn’t thought that pension funds were sort of sitting on this sort of leverage and would find themselves unwinding it in this way. You know, are we moving into a new era where we need to keep our eyes open as it were?

Howard Davies 13:24

I think it could be, I mean, the European Systemic Risk Board, which is a Eurozone entity, but which obviously, you know, no one pays attention to, they came out with some very cautionary words about the future of the Eurozone financial system and the likelihood of significant losses in banks and argued indeed, for more bank capital, I wouldn’t follow them in that direction at this point, but I mean, that, you know, this is not just a domestic issue. I think that the pension business, the EDI stuff, which was pretty obscure, I did know a little bit about it, because I was chair of an insurance company, which had bought up a lot of pension funds. So I sort of understood a bit about it. But I think one thing that we’re not very good at yet, and I think probably the central banks are thinking hard about it now, is that there may be some things where the sheer speed of change is enough to cause trouble on quite a significant scale. Even if, you know, you might say, well, the adjustment is one that perhaps people envisage. I mean, plenty of people have thought that base rates might get up to four or 5%. But what they didn’t think of was the idea that the swap rate should jump by a couple of percent in an afternoon. And suddenly that speed of change meant that it was very difficult for people to adjust to it. And so if you said, you know, will the EDI market collapse if we have five years swap rates at 4.9%? I think probably people will say, ‘well, no, no, no,’ you know, people will sort of manage their positions and think about it etcetera. But if you do it tomorrow, you know, they can’t. They haven’t been able to manage their position, I’m unable to see this coming. And where are the analysis of metrics of financial instability? It tends not to take very easily account of the suddenness. And that’s I think what we found last week, the Bank of England stepped in and has calm things down, but it was just the speed of change, which meant that nobody could prepare for it. Nobody could hedge for it, essentially. You know, that nobody could manage their position down. And that’s the thing that is very nerve-wracking, I think.

Neil Collins 15:36

How much is it a product of the sort of burgeoning species of derivatives of one sort or another, and the increasing complexity of the derivatives, some of which seem to me to be designed for the benefit of the generators of them rather than something which is a genuine tool to help the pension fund, in this case, manage its liabilities? I’m deeply suspicious of anything which is complex. And these are indeed complex.

Howard Davies 16:12

No, I think it’s an interesting point. I mean, one of the post-global financial crisis reforms, which was more talked about in the US than here, but did have any effect here, was that a lot of the lesson of the big sort of tumble in the markets as a result of subprime and all of that, one of the lessons of that was that a lot of the derivatives transactions around these instruments were bespoke OTC trades, which were extremely difficult to unpick, and that created the vertiginous fall in prices because even when banks sort of said, well, I’d quite like to get out of this, I’m happy to take my losses, crystallise them, and even when there were hedge funds, who actually said, ‘well, we think this price adjustment may have gone too far we thought we’d be buying in’ the trade couldn’t be done.

Jonathan Ford 17:02

Can I just jump in just as a definitional point that OTC in this context means not traded on an exchange, it’s basically party-to-party trades.

Howard Davies 17:10

Exactly. And these were very complicated, and as a result, sensible trades that could have mitigated the financial crisis couldn’t be done, because nobody knew what the prices were and the transactions were so complicated. They couldn’t easily be unpicked. Subsequent to the financial crisis, a lot of derivatives trades were forced on market so they were forced on exchange. And they were standardised to quite a large extent. That has had a stabilising effect. And so in general, Neil, I would say that the derivatives problem is not as severe as it was in 2007-2008. But it does appear that in this case, there were some very complex transactions involving a range of counterparties, which were close to the sort of complex rather sort of inward transactions that were at the heart of the problems of the subprime crisis in 2007-8, but I would say, in most areas of the market, it has been responded to in a reasonably effective way.

Jonathan Ford 18:12

Can I turn to another aspect of this? One of the phrases which people have started using? I have to say it wasn’t one that I’ve historically heard much of is the expression fiscal dominance. And fiscal dominance, as I understand it is basically where you have so much debt knocking around that the supposedly independent central bank becomes unwilling or reluctant to use the levers at its disposal to move interest rates around because it doesn’t want to make the government’s position unfinancible. Do you think this is a real concern to the markets? Is there a real risk that people think that the bank’s independence has been taken away from it by this situation?

Howard Davies 18:56

Yeah. Well, you may say that the phrases are relatively new to you, but I have to say among central bankers in covens, and places where they meet….

Neil Collins 19:09

In other words, they’re bullied by their governments to keep interest rates lower than they might otherwise like.

Jonathan Ford 19:17

But the cat is out of the bag.

Howard Davies 19:17

That perception, they spent a lot of time trying to explain why it is an incorrect perception. This came up, of course, at the beginning of COVID, where the question was, well, is the bank engaging in this massive QE as it then was, in order to stabilise financial conditions, which is legit, that’s what it’s supposed to do? Or is it doing it simply in order to mop up guilts that the government is issuing for its own purposes, and there was an argument for a while that the bank was engaging in March 2020 and April 2020, that it was fiscal dominance, in other words, the amount they were putting in there was clearly determined by the amount that the government was pushing out? And the bank argued strenuously that that wasn’t the case. Their objectives remained monetary stability and financial stability, that had they not been prepared to inject money that the, you know, you’d have had negative inflation, you’d have had the price level falling actual deflation and that you’d also have had instability in markets, I thought that the bank was right about that. What they did was something that was necessary, I think you would have had actual deflation, which I don’t think is a comfortable position to be in. So then I think they managed to fend off this argument. And it did sort of die away by the summer of 2020. And when people saw how serious the issues were, people accepted that the central bank did what they had to do. Now you get to back into a slightly different position where once again, people are saying, well, you know, is the bank doing this? Now, they will say, ‘well, they didn’t, because they were doing it for financial stability, and they made it very clear.’ And I personally think they had a perfectly good case. We could see what was going on in this market. This was an irregular market. And we should expect that our central bank will intervene if the markets have become completely unstable and dysfunctional. And that’s what they did. And I think they did that. For financial stability purposes.

Jonathan Ford 21:23
You’re talking here about the intervention in the last few days and gilt market?

Howard Davies 21:26

Yeah, I am.

Neil Collins 21:27

I think most people would agree that the emergency intervention was essential. I don’t think anybody is seriously saying the bank should have sat on its hands and let the markets decline or collapse even. Do you not think, though, that if you go back further to a year or so that the bank was blind to see the risks of holding interest rates at what was essentially almost a nominal rate, at a time when conditions were clearly starting to deteriorate. And this was getting clearly less and less appropriate as the months went by?

Howard Davies 22:08

I can only agree with that, because I did actually say myself, and I’ve been reminded recently, in an interview I gave on July 2021, where I argued that rates should start to rise, which wasn’t a hugely popular position at the time. Question, though, is why? Now there’s obviously two hypotheses, well there’s plenty of hypotheses, but let’s take two. One is that they, you know, were bullied by the government and decided that, you know, they ought to let this run a bit, take a few risks with inflation, because it would be very unpopular, if they put up rates, as we were still emerging from COVID, etc. Alternative two is that actually the bank simply took a different view on the domestic price pressures. And indeed, at the time, in July 2021, they were arguing that these inflationary pressures were transitory, the exact same word was used by the Fed, and indeed by the ECB. And it wasn’t until November that the Fed – Powell rather explicitly said to Congress, we are retiring the word transitory, which is, was quite amusing at the time. Then they did start to raise rates. Now, I’m a charitable sort. And I think that it was that the bank itself didn’t think that the labour market was evolving in the way that it has done. I did think that because perhaps if you’re an employer of 60,000, people as we are, we could see that there were people who didn’t want to come back, you know, they were working from home, and they were going to take early retirement, there were people who were long term sick, we had more of those. And you can see, that’s a big issue. I also, of course, attach some importance to Brexit, as I, as I might point out, a migration of labour went out and didn’t come back when the economy picked back up again, but that’s probably not the most important feature. You know, my own way of thinking was that the labour market is tighter than the Bank of England thought it was. And also, I gotta say, from my own personal point of view, to be honest, you know, that I’m just a pessimist about these things. And I was brought up at a time when inflation was much stronger. I was in the Treasury on the Monetary Policy Department of the Treasury when inflation was 18%. And, you know, the UK seems to be more prone to inflation. It just does.

Neil Collins 24:25

I remember those times rather vividly since I’ve been in finance almost as long as you have, I think, probably about the same.

Jonathan Ford 24:34

So we are where we are. The government has put out its fiscal event. It’s received this terrible reaction in the markets. It’s hard to get the Bank of England to step in. Do you think that there is a way in which she can work her way through this and restore confidence and trust in their plans? Do you think they can just press on and reassure the market with a Spending Plan?

Howard Davies 25:01

I think it’s possible, I think let’s take a slightly more slightly charitable view. The initial market disruption has eased off some extent by the end of the week, you know, the pound has kind of stabilised at a slightly lower level and the gilt market disruption has been calmed down by the Bank of England. So the meltdown hypotheses that we were looking at on Tuesday don’t seem to be where we are on Friday, having sidelined the OBR initially, what they’ve now done is make the OBR the central policy maker for the government as far as I can see.

Jonathan Ford 25:39

That’s the Office of Budget Responsibility.

Howard Davies 25:43

I think the question is, how will they judge this and what promises the government can make about you know, future spending cuts and future revenue-raising initiatives of one sort or another, and I’m sure there is a means of producing a forecast that the OBR will approve which achieves financial stability at some date in the future, or fiscal stability, I should say.

Jonathan Ford 26:09

Do you think there’s been a worse received budget than this one?

Howard Davies 26:12

If you look back at – the analogy people are often producing is that is the Tony Barber dash for growth. Because at the time it was well received? Yeah. Because people did sort of believe it. It wasn’t until three years later that it unravelled. So you know, if I were them, I’d be encouraging myself to say, well, the really lousy budgets are the ones that do well on the day.

Neil Collins 26:37

Yeah, well, I suppose they’ve learned something from that since BArber was shooting for 5% growth, which seems absolutely incredible now, so two and a half percent sounds rather modest by comparison.

Howard Davies 26:48

Yes, well, yeah, two and a half is the new five.

Neil Collins 26:55

That was a long time in finance with Jonathan Ford and Neil Collins, editing and production, Spy Nick Hilton. And our sponsorship partner is briefcase dot news. Join us again next week.