Unravelling the Endgame of Trussonomics - What The Heck Was Liz Truss Thinking?
What does the UK, USA, Japan, China and the EU have in common? Unbearably High Debt-to-GDP. Could the mini-Budget have been a magical panacea?
History is written by the victors - and hence it comes as no surprise that Liz Truss’s capitulation from 10 Downing St has resulted in her being branded as incompetence incarnate. But in an alternate universe, her doppelgänger is currently being hailed for the precociousness of her mini-Budget policies - and as the savior of the post-Brexit UK economy.
But what happened in this universe that led to Truss becoming the shortest-serving UK PM in history (45 days)? We know that it all started with last month’s widely-reported pension fund debacle, that was kicked off with the announcement of the disastrous mini-Budget and led to an unravelling of the pound in forex markets - due to a drop in market confidence of the UK government’s ability to fund its fiscal freewheeling. This ultimately resulted in UK pension funds being forced to unwind their naked LDI exposures as their derivative positions started inviting unserviceable collateral calls. If you’re not following, no worries, as the following excellent resources have got your back:
The reason the BoE is buying long gilts; an LDI blow-up | FT
Analysis: Under water - How the Bank of England threw markets a lifeline | Reuters
What do soaring gilt yields mean for DB pension funds? | Twitter
But why didn’t Truss and her recently-booted Finance Minister Kwasi Kwarteng identify a risk of such magnitude in advance? The more astute amongst you will be aware that the pension fund LDI debacle wasn’t a tragedy of solvency - most global pension funds should no longer be underfunded today, as the present value of their future pension liabilities have diminished under the the recent dramatic interest rate hikes globally. Rather, the risk was logistical in nature, as UK pension funds who were unable to post more collateral on their derivative positions (and didn’t want to leave their LDI positions naked) needed more time to obtain the necessary approvals for posting collateral in excess of their pre-determined risk budgets. We’re talking about a week at most, during which their solvency was never under question.
But because the pound was falling at such a rapid pace and interest rate hikes were expected to continue unabated, UK pension funds who unwinded their LDI positions themselves contributed further to the pound’s self-fulfilling downward spiral - as their peers were incentivized to follow in their footsteps and subscribe to the doom flywheel. Ultimately, this required the Bank of England to step in and halt the pound’s relentless fall by essentially promising “Whatever It Takes” with quasi-Yield Curve Control (pun intended) at the tail-end of the yield curve.
Still following? Then you would agree with me that this is a very forgivable sort of offense, as something like a logistical oversight (in contrast to a solvency oversight) was relatively insignificant in the grand scheme of things, and would have been very difficult to identify from the extremely high vantage point of the ivory towers at 10 Downing St. While it certainly remains Kwasi’s and Truss’s responsibilities to have prevented this earlier, it would have been the kind of mistake I could see myself making as well. The nature of the risk would be described similarly to a black swan risk.
However, what’s done is done - and both actors have taken responsibility by falling on their swords to usher in a new epoch of Tory leadership. Still the question remains - if this logistical muddle didn’t metamorphosize into a beast of such epic proportions, what would Kwasi’s and Truss’s economic plan for the UK economy have looked like? Surely with their initial shows of confidence, they must have had lengthy discussions with their Cabinet into the wee hours of the morning discussing the place of a post-Brexit UK in the new world order. What would those grand ambitions for the UK have looked like? Or in an alternate universe, what would PM Truss be celebrated for in a few years’ time?
That’s what we’re here to discuss. Fair warning - I think Lizzy and Kwasi could have been right. In an alternate universe, of course.
Check out my latest article below about whether the P/B Ratio Is Still Relevant To Investors Today!
How Things Got This Way: A Refresher
Before I map out Truss’s war plan, we’re going to need some context. For the sake of brevity, I’m going to assume that most of you have read the news lately and that there’s no need to repeat what’s already in the public sphere - i.e. how Trussonomics would have rendered the UK economy in absolute shambles due to its unbridled fiscal indiscipline. If you need a refresher on how irresponsible the mini-Budget policies could have been, Google is your best friend.
The basic criticism of Trussonomics can be boiled down to the fact that it never explained how it would fund its ambitious policies. There were wonton fiscal measures aimed at stimulating the economy and raising the post-Brexit UK economy back on even competitive footing with its EU economy brethren - such as the unpopular ditching of bankers’ bonus caps to attract foreign talent, cuts to the National Insurance payroll tax to alleviate rising energy burdens, and tax cuts for banks & insurance companies aimed at restoring the UK’s legacy position as a global financial center. I won’t go into all the details here, but I don’t really need to. All you need to know to understand why it was so unpopular amongst even its main beneficiaries was that there was no explanation about how to reconcile the planned fiscal expenditure with the national budget. The articles below do a much better job of explaining this predicament than I ever will - so have a look at them if you want to understand what a massive hole the mini-Budget would have created in the UK’s government budget (on a steady-state basis):
Amidst a political climate of rapidly rising inflation partly contributed by a faraway war on Europe’s eastern border, it is completely understandable why a fiscally irresponsible budget would have been unpopular and stoked the tensions it did. The basic idea here was that runaway fiscal spending into an abyss would have fueled even further domestic inflation, eventually leading to the UK following in the footsteps of Turkey and Argentina - for the simple reason that money wasn’t free. In fact, it was precisely these fears which led foreign investors to sell their pounds which sparked the panic in forex markets that got the ball rolling in the first place. Now throw in a sprinkle of Tory political infighting - and you have the perfect recipe for an encore of ‘Snapping of the Rubberbands’.
However, both Kwasi and Truss could have been perfectly aware of these factors even before they announced the mini-Budget - and yet they pushed it through anyway. On one hand, it could simply mean that they were ridiculously incompetent - in fact, this is the consensus narrative right now. However, applying Howard Marks’ second-level thinking would naturally lead one to ask - what if the duo weren’t absolute idiots? What if we gave them the benefit of the doubt, and entertained what a mini-Budget could have looked like if it was actually a well thought-out plan? What if Kwasi and Truss had tortured themselves over the political implications of their unpopular policies, but ultimately still pushed it through despite the costs - because they genuinely believed that the tradeoffs to the UK economy were worth it? What would that endgame look like?
Put your tinfoil hat on, McFly - we’re going Back to the Future.
The Endgame of Trussonomics
As we’ve discussed above, the pension fund debacle was mainly due to a logistical error rather than a legitimate solvency issue - and would readily qualify as a black swan risk in nature due to how insignificant a delay spanning a week would ordinarily have been in contrast to an economic masterplan spanning 20 years. I’m not trying to justify the duo’s mistakes, but let’s be honest - we’ve all made tiny oversights of this nature that eventually compounded into monsters at our own jobs as well.
Hence, let us assume that the pension fund debacle never occurred, and that Kwasi and Truss were given a chance to see their mini-Budget to fruition. What was the endgame of Trussonomics? How did Kwasi and Truss envision the future of the UK economy, and its place within the wider global economy? What did they actually seek to achieve?
Firstly, let us start with the UK economy’s competitive position in the present-day. Post-Brexit, the future of the UK economy has been reduced to a shadow of its former self - it isn’t an export economy, with net exports effectively being 0% of its GDP (exports: 27%, imports: 28%). While this implies that their domestic economy is self-sufficient, there also isn’t a lot of room for excess growth when you are already a mature economy like the UK. And with London slowly but surely relinquishing its legacy status as Europe’s financial center to Brussels, it’s not surprising why some might feel that the UK will eventually lose its luster on the world stage.
Now throw in the massive unfunded fiscal stimulus that the mini-Budget was supposed to introduce. Without a hefty amount of net exports contributing a steady current account surplus, this yawning chasm of a domestic deficit would have eventually led to a balance of payments gap - prompting legitimate fears of a sterling crash as foreign investors fled the pound for safer pastures (which actually did happen). To be clear, the Bank of England (BoE) has ample foreign reserves at an estimated USD 100B and should be able to sufficiently manage a ‘death by a thousand cuts’ forex decline - so the much bandied-about solvency issue of the UK economy wasn’t an urgent problem which they had to solve overnight.
How would Trussonomics have managed this deficit? Well, the strategy of supply-side economics is basically that lower taxes and greater government investment would eventually lead to higher productivity in the real economy - which would then lead to higher tax contributions that would offset the initial tax cuts. As an example, the mini-Budget was clearly designed to attract a greater inflow of capable foreign talent which would ideally generate more profits in the domestic banking sector, and therefore contribute more taxes than the existing steady-state economy ever could. Likewise, a cut in payroll taxes should enable more consumer spending which could revitalize the pandemic-hit ailing UK economy. This is all within the status quo, and most of you would already know this.
However, for all its merits, the mini-Budget still left a loose end unsolved - the inability to fund its own expenses. It would not be completely inaccurate to say that all the supposed future benefits from the ambitious growth policy was based on hopes and dreams - hopes that increased real productivity would materialize from a lower tax burden, and dreams that supply-side economics would eventually trickle down to the masses. There was no room for mistakes, as the consequences of miscalculation would result in the aforementioned yawning chasm of a domestic deficit potentially contributing to a balance of payments crisis the likes of Turkey - according to opposition politicians, anyway.
This left only further government borrowing for funding as a course of action - and with the UK’s public debt-to-GDP already standing at 85% and its systemic debt-to-GDP at nearly 270%, further indebtedness was clearly not an option. And when you’re swimming in a hostile political environment fueled by both rebels within your own party and Labour, the calculated risk gets turned into a political narrative of Armageddon and the death of Empire.
However, I’ve already mentioned how Kwasi and Truss could have already been aware of what was at stake prior to announcing the mini-Budget - and yet they decided to push it through anyway, with the presumption here being that they thought the risk tradeoff was justified. Obviously, the logistical nightmare which snowballed into the pension fund debacle didn’t help - but again, we’re giving them the benefit of the doubt here that it didn’t happen. So what gives in the original plan had the UK pension funds not folded? How did Trussonomics plan to solve the unfunded aspect of the mini-Budget?
Here’s where we leave the realm of empiricism and step into the territory of anecdotes. My personal belief is that leaving the mini-Budget unfunded was part of the plan. The endgame of Trussonomics was to allow inflation and the sterling decline in forex markets to run its course - and emerge on the other side with the currency sporting much weaker purchasing power, and perhaps even trading below parity to the USD. Of course, the Exchequer would have discussed risk management strategies amply with the BoE before pulling the trigger - and both sides might have determined in advance that the gradual slide of the pound could be manageable and unproblematic. But letting a weaker forex (resulting from high inflation) serve as a release valve for the balance of payments pressures would have been part of the plan.
Let’s explore what this course of action would have meant for the UK economy. Firstly, it would have made the sterling more affordable for foreign parties, which could have potentially stimulated and created a stronger domestic export sector - something the post-Brexit UK economy sorely needs for its long-term sustainability. This would also have helped fund the “new UK’s” balance of payments to a certain extent, since there would be a relative increase in the current account. Secondly, it would also have helped stimulate real productivity, owing to the inflow of foreign capital and talent into the country.
However, there’s also a much more ingenious mechanism at play as well - an opportunity for the UK to reduce its untenable debt-to-GDP. As we’ve mentioned above, the UK’s govt debt-to-GDP is currently sitting at a lofty 85% - hence being able to reduce the country’s debt-to-GDP will go a long way towards enabling the current stimulus plan and creating fiscal headroom for the future. Imagine pulling off fiscal stimulus at the same time as reducing your govt debt-to-GDP - if pulled off effectively, it would have been a magic solution akin to ‘killing two birds with one stone’.
HOW DOES THIS WORK? For this, I have to thank the esteemed Russell Napier for his recent interview which explores the future of global economics. He talks about much more than just this topic in his interview - but basically, the idea is that there are actually two ways to reduce a country’s debt-to-GDP. One, you approach it in a straightforward manner by paying down debt. Two, you deliberately stoke inflation in your currency - such that nominal GDP grows by faster than the increase in nominal debt. Of course, this wouldn’t really do anything for real GDP growth - since high inflation offsets high nominal GDP growth. But since debt doesn’t experience inflation, you can very effectively reduce your debt-to-GDP in this manner if you are willing to embrace the pain of high inflation - which a UK policymaker could frictionlessly blame on the war in Ukraine in the current geopolitical environment. It is an enchanting one-two punch that knocks the light out on fiscal indebtedness and stimulates the economy at the same time - this is the economic equivalent of transmuting lead into gold.
In fact, Russell goes on to explain how this approach towards reducing debt-to-GDP was actually the status quo approach for countries seeking to reduce their high debt levels immediately after WW2. It would be completely within the ordinary for a central bank governor to observe the historical success of such an approach, and seek to implement it again in the present-day to solve the current high levels of public indebtedness. Reading this article actually helped me draw intuitive parallels to Abenomics ‘three arrows’ and China’s past decade of relentless SoE stimulus into non-productive sectors - both countries whose fiscal policies I had never fully wrapped my head around before, and both of which also sport implausibly high levels of systemic debt-to-GDP. You can read more about my take on China’s systemic indebtedness in my article linked below from around a year ago:
In fact, it’s not just the aforementioned countries who might be seeking to reduce their public debt-to-GDP in this manner. The article linked below was written by a different Russell (who is also an excellent macro analyst), and helped me connect the dots of this debt alleviation approach to recent US Fed and Treasury policy. I’d invite you to read his article in full to get his complete take - but the general idea here is to encourage a return to the pro-labour policies of the FDR era in order to effect the aforementioned inflationary policies to reduce public indebtedness.
I would highly encourage anyone with an interest in exploring what the future landscape of global macro might look like to read the above articles by both Russells in detail. Reading these really helped me collect all my disparate thoughts about macroeconomics together into a cohesive global macro narrative - and provided much-needed insight to fill in the gaps of my understanding regarding the current global macroeconomic landscape and its possible future trajectory.
In any case, this final piece of the puzzle helps us answer the question of what the endgame of a successfully executed Trussonomics policy might have looked like:
The unfunded mini-Budget could have enabled domestic stimulus and greater competitiveness on the global stage, inviting the classical benefits of supply-side economics such as higher real productivity which could offset the tax cuts - at the expense of high inflation;
A deliberate and managed depreciation of the sterling (resulting from high domestic inflation) could have contributed stimulus resulting from greater foreign investment - which might have encouraged a stronger domestic export sector in a post-Brexit UK economy. This would help increase the current account surplus and improve their balance of payments position;
The resulting high but managed inflation would also have contributed to greater nominal GDP growth, which would have reduced the UK’s nominal debt-to-GDP - enabling the possibility of further stimulus via debt, or simply greater fiscal headroom to withstand external shocks. This was the established post-WW2 playbook of countries who sought to reduce their high levels of debt-to GDP, so credibility for such a strategy already exist.
Of course, all of this assumes that the logistical bottleneck experienced by the UK pension funds never happened - which to be fair, is a leap of faith to make. But suffice to say, it is amply possible to justify Trussonomics as a legitimate approach to economic policy which could have resulted in a stronger “new UK”. In an alternate universe, the Truss/Kwasi duo from Earth 47 would have spotted the potential pension fund flaw in the plan and easily mitigated the fallout from it in advance - especially given its relative insignificance as compared to the sheer and grand scale of the aforementioned masterplan. For the Truss in our universe to have fallen to such a triffling foe is really a shame - for as we can see in the above narrative, this was no “great supine protoplasmic invertebrate jelly” of a plan.
If there was one mistake that Truss could perhaps be blamed for, it might be that she did not sufficiently consider the scale of the political fallout from any potential failure in such an ambitious policy. Any nail who sticks out too much invites being hammered; and with treasonous infighting still prevalent within her own party and a deteriorating domestic economy spiraling out of control, any policy as unpopular as tax cuts for the rich begs serious reconsideration. Perhaps she found assurance within the altruism of her actions - that her mini-Budget was genuinely in the best long-term interest of the UK economy and that the wider public would eventually come to appreciate her willingness to sacrifice her political interests to do what was right for the country. If so, she might have miscalculated the extent of the vicious backbiting nature of parliamentary politics - as well as the self-defeating complexion of the tragedy of the commons.
I would also like to qualify that I am no expert in UK macroeconomics, and there could just as likely be an equally fatal flaw in my entire narrative which renders the lifespan of this whole thesis shorter than lettuce. However, it is my experience that the best way to discover your blind spots is by being wrong on the Internet - and I would happily embrace such pushback, as it would further help me refine my understanding of the current global macro environment.
On my part, I would like to personally thank Miss Truss and Mr Kwasi for such exemplary thinking and their spirited fight for the greater good. I hope someone helps me share this article to them in their present time of difficulty. Perhaps the philosopher kings of Plato live on.
The Queen Is Dead, The Queen Is Dead… Long Live The King?
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