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Markets are not neutral

It is politically advantageous to pretend they are — but it is untrue

Artillery Row

Perhaps the most annoying phrase in modern politics is “spooking the markets” — a cringe-inducing cliché which took on a life of its own in the disastrous aftermath of the infamous “mini-budget” last year. With the pound collapsing and yields on government bonds soaring, politicians and commentators couldn’t stop referring to “the markets” as if they were a small child terrified by the appearance of a Truss or Kwarteng-shaped ghost.

As the reaction to the mini-budget demonstrated, there is a widespread view amongst modern liberals, rooted in the principles of Friedman and Hayek, that markets are omniscient arbiters of judgement and value. Markets automatically make calculations and respond to political events on a neutral, almost scientific basis. Kwarteng, who was trying to cut taxes at the same time as increasing borrowing, didn’t have his sums right and therefore bond yields went up — markets were “spooked”.

Sir Keir Starmer reflected this position when he said, “I’ll tell you what will stabilise the markets, it is an incoming Labour government … with absolutely clear fiscal rules.” In other words, navigating financial markets successfully is a mathematical endeavour: it is about making sure the numbers work according to “absolutely clear fiscal rules”.

The truth is that markets often act in irrational ways

Whilst I have little time for the kind of policies espoused by Truss and Kwarteng (and criticised the assumptions underpinning the mini-budget), the idea that markets work rationally in this way is completely absurd. The medium-run cost of Kwarteng’s tax cuts was predicted to be around £2 billion: a sizable sum, but nothing compared to the £150 billion energy package that was passed a matter of days previously. This was in turn dwarfed by the approximately £400 billion that the government is estimated to have spent during the coronavirus pandemic. Why did £2 billion of tax cuts “sabotage” the country’s standing on financial markets when infinitely larger measures had barely any impact at all?

The truth is that markets often act in irrational ways and follow subjective trends — sometimes in direct contradiction to the available evidence. Global oil prices are a good example of this. During the initial invasion of Iraq by coalition forces in 2003, oil prices barely moved, despite major threats to supply in the Middle East’s second-largest producer of oil. When ISIS swept across Iraq in 2014, prices spiked — despite the fact that the group failed to capture any of the country’s major oil facilities and therefore had little impact on supply.

What mattered in these two cases was not the reality on the ground, but the perception of what was happening in the eyes of speculators. In 2014, a popular narrative was established that the rise of ISIS threatened the world’s oil supplies, and therefore prices must rise. In 2003, there was no such narrative, and prices remained stable. There is no intrinsic logic to this — but that is how markets now work. Traders such as George Soros have made billions not by correctly analysing and predicting fundamentals, but by jumping on market “trends” that often have little basis in real-world conditions.

We saw the power of “narratives” during the Truss debacle. Politicians and bankers were outraged, for example, that the government blocked the publication of mini-budget forecasts from the supposedly sacrosanct Office for Budget Responsibility (OBR). The OBR is nothing more than a frequently wrong quango established by George Osborne, with pretty much the sole intention of having a dig at the previous Labour government.

Is the publication of a few (almost certainly wrong) forecasts from such a body so essential? Of course not — but that’s not the point. A story set in that Truss and Kwarteng were “avoiding OBR scrutiny” for their mad policy of “unfunded tax cuts”. Eventually Jeremy Hunt was wheeled out in a smart suit to utter the platitudes traders wanted to hear, whilst keeping the government’s most expensive spending commitments, at which point the markets “calmed”. The whole thing really is as superficial as that.

Bond vigilantes are in a powerful position to set the terms

Truss isn’t the only one to have experienced something similar. Bill Clinton was initially elected on a left-wing platform that promised to cut taxes for the squeezed middle-class and increase government spending. It was only after bond traders started to sell US Treasuries, raising the interest rates on government debt, that Clinton dropped most of this. François Mitterrand had to do likewise in the eighties. Governments of all political leanings should be trying to work out how to tame the power of the “bond vigilantes” because it is never clear when or why they are going to strike.

It’s true that a country which borrows as much as Britain is dependent on the goodness of strangers. Bond issuers aren’t obliged to give us their cash, and they are in a powerful position to set the terms. That would seem to be a strong argument in favour of reducing government borrowing and therefore lessening the country’s exposure to foreign creditors. Bond vigilantes are also less powerful at times of lower inflation and lower interest rates, which is strong motivation in itself to get prices back under control.

It might have been politically useful for Sunak and Starmer to pretend that the market reaction to the mini-budget was a wholly rational response to the policies of their political opponents. Whatever one’s politics, it’s a worrying state of affairs when financial markets are able to push governments around at whim, particularly when they operate in such a subjective and illogical fashion. It’s time to think carefully about how markets work and how to reduce their sway over elected governments.

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