It is often quipped by pundits and comedians that Liz Truss killed the economy. Like many lies, this has now been reported so many times that it is becoming received wisdom, but it is really just an urban myth.

The evidence doesn’t support it. Now that 10-year gilt yields are above the giddy heights reached in October 2022 under Truss, and short-term rates have doubled, it is time to reexamine what really happened to the markets in October last year and whether Liz Truss’s proposals to fix the economy would have worked.

Deja vu all over again

Before getting into that, it is probably worth setting up some background. If you look at the Bank of England website, it has a page entitled Official Bank Rate history: the graph only runs from 2013, but the data table below it goes back to 1975.

LDI investments were a financial fire well before Truss came to power

For most of this time the Bank was changing the rate many times a year: in 1975 they changed it 13 times, starting from 11.25 per cent, going as low as 9.75 per cent in April, as high as 12 per cent in October and finishing the year back at 11.25 per cent. In 1982 the rate was changed 32 times, although it was an easier market to follow, as rates declined steadily from 14.38 per cent in January to 9.13 per cent in November. By the 1990s and the early 2000s inflation was under control, and rates were changed about four times a year, give or take, but interest rates were still high enough for investors to make money and still volatile enough for bond traders to make money.

In March 2009 this all came to a grinding halt, and Bank rates remained unchanged, at a mere 0.5 per cent, for seven years. In the next six years they changed only six times, dropping as low as 0.1 per cent before returning to 0.5 per cent at the beginning of 2022. For about a dozen years, then, interest rates were moribund. Gilt yields followed the Bank’s lead, and average yields fell steadily from around 4.5 per cent for 10-year gilts in July 2009, to 0.095 in July 2020. Incredibly, even ultra-long (50-year) gilts saw averaged yields of under 0.5 per cent from April to July 2020.

The lack of movement in Bank of England base rates and the steady decline of gilt yields caused three important things to happen:

1. The bond traders that filled the banks and broking houses of the City of London appear to have stopped bothering to read the Bank of England’s reports. They have stopped watching every possible inflation figure that could have influenced the bond price.
2. Senior traders with experience in trading volatile bond markets either retired, gave up due to boredom or moved into junk bond trading.
3. Pension funds, the natural investors in Government Bonds, had to find other ways to pay for their pension liabilities, especially defined benefit pensions. This encouraged (or forced) them to move into Liability Driven Investments (LDI) to meet their pension liabilities, putting their bond holdings up as collateral.

As most of the population don’t follow bond markets and their main exposure to interest rates is through their mortgages, many people will be unaware that bond yields didn’t suddenly increase under Liz Truss’s premiership. They started increasing in February 2021 when average short-dated yields went from 0.05 per cent to 0.45 per cent in a month — that is, about a 1,000 per cent increase. Even ten-year gilts increased from 0.2163 to 0.851, an increase of 293 per cent. They continued to increase, reaching a high of 2.5 per cent on 13 June, all whilst Rishi Sunak was Chancellor and Boris Johnson was Prime Minister. By the time Truss became Prime Minister on 5 September, 10-year gilt yields had already risen to just under three per cent.

Sunak’s tenure as the Chancellor of the Exchequer saw 10-year gilt yields increase by 376 per cent. His replacement, Nadhim Zahawi, presided over 10-year gilt yields rising by 38 per cent. Neither Chancellor saw many complaints about this from the press, however. Whilst Kwasi Kwarteng was Chancellor, 10-year gilt yields continued to increase, up 41 per cent from 3.0865 to 4.3462. This is not dissimilar from the increase under Zahawi and certainly less than the increase under Sunak, but still the commentary and comedy circuit is sure that it was the Truss/Kwarteng Government that broke the UK economy.

This brings us back to LDI investments and the pension liability problems created by over a decade of ultra-low interest rates. A very interesting article was published in the Financial Times, dated 21 July 2022 — several months before Truss took over as Prime Minister from Johnson. It was written by Toby Nangle, a former global head of asset allocation at an American asset management firm with over $580 billion under management. The article warned of the large amount of extra collateral already required for pension funds using Liability Driven Investments (LDI). The extra collateral required was estimated to be as high as £380 billion — in July 2022.

Nangle acknowledges that although pension funds using LDIs would have stress-tested for rising yields, bond yields had by then (July 2022) risen by more than standard stress tests ever expected and so had already wiped out any collateral buffers held by the pension funds. Nangle predicted that these buffers would need to be rebuilt so pension funds would have to sell assets. Here I will quote Nangle in full as he succinctly puts the blame for this where it belongs:

LDI managers claim that their activities pose no systemic risk, and I read the Bank of England financial policy committee’s silence as agreement. But UK pension funds are collectively very large derivative counterparties and they move together.

Rarely has a warning been more accurate or pertinent. Remember, this was published in July 2022 — Zahawi had been Chancellor for two weeks following Sunak’s two and a half years as Chancellor. LDIs started long before Sunak, though; they were being used in the early 2000s. KPMG estimates there were over 500 LDI mandates in 2008, increasing to almost 2,000 by 2016. According to Reuters, LDIs were worth £1.6 trillion by 2021 when Sunak was still Chancellor.

LDI investments were a financial fire already, smouldering well before Truss came to power but unknown to the mainstream media, or the comedy circuit, or the army of Twitter bullies who would soon give up their recent careers as armchair epidemiologists to become armchair bond traders.

It is LDI investors who should have been adopting the habits of 1980s and 1990s bond traders and reading every publication, listening to every utterance and watching every raised eyebrow at the Bank of England. Had they read the minutes of the Bank of England’s August MPC meeting, they might not have panicked so much when the September MPC minutes, released on 22 September, stated:

The Committee also voted unanimously to reduce the stock of purchased UK government bonds, financed by the issuance of central bank reserves, by £80 billion over the next twelve months, to a total of £758 billion, in line with the strategy set out in the minutes of the August MPC meeting.

Or maybe they panicked after reading in the same publication that although five MPC members voted for a 0.5 per cent increase, three voted for a 0.75 per cent increase and only one for a 0.25 per cent increase. Both statements would have caused panic in those responsible for pension funds whose LDI collateral buffers had already been exhausted, regardless of what was announced in the Truss/Kwarteng mini-budget on the following day.

Of course, what followed is well known: turmoil in the bond market as funds struggled to sell ahead of the Bank of England’s bond selling, coupled with the falling pound due to both the US Federal Reserve and the Eurozone’s European Central Bank increasing their rates by 0.75 per cent whilst the UK only increased by 0.5 per cent, with the US indicating that it would continue to increase rates until the end of the year.

Truss became a convenient scapegoat for a generation of borrowers

Incredibly, both the bond and the currency debacle were blamed entirely on the Truss/Kwarteng mini-budget and their “unfunded” tax-cuts — but not on their equally “unfunded” but much, much larger energy subsidies. Truss was forced to replace her Chancellor with Jeremy Hunt. Soon after she was also replaced, by Sunak. Like sacrifices thrown into an erupting volcano, their replacement was an attempt to quell the financial markets. In fact, it was really to quell the baying media — egged on by the Conservative Wets who saw this as a chance to replace Truss with their choice for the leadership: a choice they had been shocked to discover was not also the choice of Conservative Party members.

As we now all know, although gilt yields fell back to about three per cent when Hunt replaced Kwarteng and later Sunak replaced Truss, over the next seven months 10-year gilt yields moved back to where they had been under Truss. This week they went even higher, hitting 4.7212. Truss became a convenient scapegoat for a generation of borrowers who have never seen interest rates above a few per cent and seemed to believe that interest rates would stay at these low rates forever, regardless of the expanded money supply. Yields have returned to the levels seen under Truss, and are predicted to go higher by the Bank of England, because government bond prices reflect current economic fundamentals. They are not mispriced.

The Truss alternative

Governments can get away with printing money if the economy is growing at a similar rate. The Bank of England printed a huge amount of money during Covid at a time when the economy was not growing, but shrinking. All non-essential businesses were closed, and people were working from home, so not using transport or services near their offices.

Truss’s plans were designed to invigorate the economy, which would have soaked up some of this excess money. The only item I disagreed with was her plan to subsidise all consumers’ energy bills, although this could have been excused as compensation for the Government’s Green Agenda. This lobby has been discouraging domestic production of oil and gas since 2007, and so it was partially responsible for the EU’s reliance on Russian gas.

In fairness to Truss, she also proposed to provide £40 billion to help with energy market liquidity, issuing 100 new oil and gas licences in the North Sea, reducing the barriers to the development of vital infrastructure as well as ending the moratorium on fracking.She was removing barriers to increasing supply in tandem with protecting consumers from higher prices.

Unfortunately, due to the subsidy’s popular support, Sunak kept the consumer energy subsidies for everyone but cancelled the fracking and other supply side reforms, thus ensuring UK prices would remain high for longer. Subsidies will cost the economy more, and the UK will remain dependent on imported gas — which is not helpful when your currency is falling against the US dollar.

The other Truss proposal that Hunt kept was returning National Insurance rates back to where they had been before Sunak (as Chancellor) increased them six months earlier. This proposal only escaped a Hunt reversal because it was due to start the following month and thus was too late to change.

Truss’s reversal of Sunak’s increase in National Insurance rates was an important boost to the economy because National Insurance is paid by both employees and employers: simultaneously reducing after-tax income for employees, discouraging them from working, as well as increasing the cost of employment, thus discouraging employers from taking on more staff. Truss also proposed to reverse the IR35 rules for the self-employed, to increase the entrepreneurs’ allowances and to remove the limits placed on bonuses. All would have encouraged skilled professionals to remain working, more importantly to remain working in the UK rather than taking their efforts to more “encouraging” environments (including several EU countries offering UK-based bankers large tax breaks to relocate).

The high cost of energy was undermining all UK businesses

Truss also proposed to reverse Chancellor Sunak’s planned increase in the corporation tax rate from 19 per cent to 25 per cent, which would have encouraged companies to remain based in the UK. Unfortunately, she didn’t propose to remove the absurd windfall taxes on oil and gas companies, even though the high cost of energy was undermining all UK businesses, whilst the high cost of oil and gas taxes (65 per cent at the time) was undermining domestic oil and gas producers. Incredibly, the Hunt/Sunak Government increased these windfall taxes to 75 per cent and kept regular corporation tax at 25 per cent.

Truss also planned to reduce stamp duty; this would have boosted a whole range of businesses as well as making buying houses cheaper without disrupting mortgage lenders’ balance sheets or discouraging house building. She should have done this across the board, though, not just for first-time buyers — that creates a bottleneck in the bottom end of the market. House supply depends as much on existing owners moving to larger properties as it does on new buyers coming in at the bottom.

Reviving the housing market helps not just building firms and building material suppliers, but also real estate agents, lawyers, surveyors, moving firms, curtain makers, painters and decorators, electricians and plumbers, furniture manufacturers, garden designers, plant nurseries, etc, etc.

Finally, the bête noire of the Truss-blaming media: her proposal to lower the top income tax bracket from 45 per cent back to 40 per cent. This was the top rate until almost the last few days of the Brown Labour Government in April 2010. Even though the 45 per cent tax bracket included many media presenters, the bile poured onto this proposal was beyond belief.

Journalists failed to understand that many high-paying service jobs are mobile — especially after Covid when everyone (including a senior Treasury civil servant) has discovered that they can live and work wherever they like and attend meetings via Zoom or Teams when necessary. Tax rates are more important than ever for keeping financial services, consulting, accounting services, legal services and other screen-based workers as residents for tax purposes in the UK. Many other financial centres have much lower taxes: the top rate of federal income tax in the US is only 37 per cent and only applies to income over $539,900 (£411,080), whilst Singapore’s top income tax rate will be 24 per cent on earnings over S$1 million (£575,800) in 2024.

Keeping high earners in London is important because the top one per cent of earners in the UK pay 28 per cent of total UK income taxes — but cost the government little to nothing. They mostly send their children to private schools and have private medical insurance and private pensions (hopefully not the LDI kind). Equally, attracting more high earners to Britain would have helped balance the books and sent a powerful signal that Britain is once again fully open for business. Instead, the media screamed “unfair”, and the policy was dropped.

Losing Truss’s economic reforms was a tragedy for the UK. As expected, the market did what markets always do: gas prices have fallen back to normal levels, so the much-prophesied horror of average energy bills over £5,000 never happened.

Instead, we still have higher mortgage rates under the Sunak/Hunt government. We haven’t got a growing economy, though, nor a thriving oil and gas industry, nor a population fully back at work, nor an entrepreneurial class of self-employed people building new businesses, nor an influx of international bankers and lawyers and accountants wanting to live and work and pay taxes in the UK. If the accountancy firms are to be believed, that tide is going in the other direction. All we got was a Chancellor who is apparently looking forward to the coming recession.