The IMF killed Labour. Black Wednesday did for Major. Will KamiKwasi budget be the end of Truss?

So the old rules about public borrowing still apply after all. Yes, governments can borrow tons of money. But it comes at a price. the more they borrow, the higher the interest rates on the burgeoning debt they’ll have to pay — and the currency will also take the strain.

At some stage, when borrowing gets out of hand, the interest rates become penal and the currency plummets.

Prime Minister Liz truss and Chancellor Kwasi Kwarteng have just found this out the hard way. From the pounding they’ve taken, it’s far from clear they’ll ever recover.

It’s understandable, to some degree, that they thought they could get away with it. For over a decade, the debt markets had happily financed government borrowing without jacking up interest rates. Governments borrowed billions to bail out the banks during the Great Crash of 2008 and to get out of the recession which followed.

Debt stayed cheap even after this borrowing binge. So few finance ministers rushed to rein it in. George osborne, tory Chancellor from 2010 to 2016, was criticised for placing too much emphasis on deficit reduction. his efforts to control public spending were stigmatised by the Left as ‘austerity’. Radical tories attacked him for not cutting taxes more boldly.

Governments far more profligate than ours were still paying peanuts to borrow billions, went the argument. the global economy was flooded with cheap money. So why not borrow, borrow, borrow? Some even called it ‘free’ money, since interest rates were so low (or even negative).

the financial response to the pandemic seemed to vindicate this view. Governments borrowed hundreds of billions more — much more than during the Great Crash

— to cope with its financial and economic consequences, to pay for furlough schemes and cash handouts for businesses. Still interest rates barely rose.

So you can perhaps see why truss and Kwarteng thought they, too, could borrow — this time to finance tax cuts and pump some growth into the economy without penalty. But something significant had changed. that something was the return of inflation, starting in 2021 and gathering in strength throughout 2022.

More experienced hands (such as former Chancellor Rishi Sunak, whom truss beat in the tory leadership race this summer) realised this was a gamechanger. that the era of cheap money was over. that you could no longer borrow with impunity. that abnormally low interest rates could not survive double-digit inflation.

But truss and Kwarteng sadly seemed to realise none of this.

It was a massive miscalculation, all the more unforgiveable because the return of inflation — and the consequences that followed from it — had been clear for some time for those with eyes to see.

As the global economy recovered from the pandemic last year, supply chains which had closed down during the plague struggled to cope with rapidly increasing demand. Shortages of everything from oil to food and copper to microchips jacked up prices in the shops and on the forecourts.

Central bankers, from America’s mighty Federal Reserve to our own Bank of england, assured us that the price rises were temporary, that they would ‘see through them’ and not act precipitately by hiking interest rates. they were wrong — big time.

By late last summer it was clear inflation was here to stay for the foreseeable future.

Still, central bankers were slow to act, worried about being blamed for taking away the cheap money punch bowl.

Russia’s invasion of Ukraine put paid to any idea that inflation was temporary. Prices of energy and food in particular spiked further. By now central banks were rushing to raise interest rates, faster and higher than would have been necessary if they’d acted earlier.

But that was water under the bridge. the new reality was clear. Money was no longer cheap. Borrowing now had a cost. the more you borrowed the higher that cost. this was even more true for governments, still sitting on trillions of debt accumulated during the Crash and the pandemic, than it was for business and individuals.

It beggars belief that truss and Kwarteng did not understand this — that they could borrow not just to pay for the energy price cap or for the tax cuts truss had promised during the leadership contest but for additional tax cuts, too.

the result was an unnecessary error of stupendous consequence. the Bank and its underwhelming Governor have not covered themselves in glory these past 18 months. But be in no doubt: this is a financial crisis created in 10 and 11 Downing Street, not threadneedle Street.

It need not have happened. the debt and currency markets had already priced in much of last Friday’s financial statement. the multi-billion pound cost of the energy price cap did not faze them. Most Western governments were doing something similar.

Rescinding the rise in national insurance and not going ahead with next April’s rise in corporation tax (on business profits) were expected and caused the markets little anxiety. If the statement had stopped there, the markets would not have reacted adversely, even without deficit and debt projections from the independent office for Budget Responsibility (oBR).

But, perhaps over-excited in the full flush of victory and buoyed by ideological conviction, truss and Kwarteng went further, bringing forward a cut in basic income tax, abolishing the top rate of income tax and reducing stamp duty. that’s what spooked the markets.

Not because the sums involved in these unexpected measures were huge — under £10 billion a year in total — but because they were unfunded and suggested a cavalier, uncontrolled attitude to borrowing on top of all the other debt being created.

Now the lack of oBR workings mattered. there was no official estimate for debt and the deficit. Vague talk of paying for it all with future growth didn’t cut it. Kwarteng then compounded it all last weekend by boasting that more tax cuts were on the way. 10 and 11 Downing Street had morphed into Amateur City.

the consequences unfolded like a financial horror film for the tories. the pound tanked, at one stage reaching its lowest point against the dollar in 230 years. the cost of Government borrowing soared, a precursor of higher interest rates all round.

the Bank warned of a ‘material risk to the UK’s financial stability’ ( though hitherto somewhat despised by truss and her followers, it was the Bank which saved the day with a multi-billion pound intervention in Government bond markets). the IMF rapped the Government’s knuckles in an unprecedented intervention.

oh yes, and Labour moved to a stratospheric and possibly unassailable lead in the polls. For some despairing tories it became hard to discern the difference between the truss Government and a bull in a china shop.

Loyalists claim all is not lost. they point to a modest recovery in sterling. they say, with some force, that the spike in Government borrowing costs was

By last summer, it was clear inf lation was here to stay

If you’re an outlier in the current financial climate, the markets will have you for breakfast

Labour’s poll lead is possibly unassailable

overdone and that interest rates (yields) on Government bonds have settled down somewhat. they tell us to ignore the IMF (I’m inclined to agree).

But calm has only been restored to financial markets because of the Bank’s intervention. that expires on october 14. Nobody knows quite what happens after that. the chances of a major change of course by the Government before then seem to me unlikely (and could be self-defeating by creating even more chaos).

It is rightly said that the world is awash in financial turmoil. Ministers have been brushing up on the Bank of Japan’s intervention to prop up the yen against the dollar (China and South Korea have also had to act) and pointing out that government bond yields have been rising everywhere, even in America.

All of this is true. But if we’re meant to draw the conclusion that nothing out of the ordinary happened in the last week in Britain, then it’s nonsense. It is precisely because there is global financial turmoil that the truss Government had a duty not to do anything stupid.

the last thing you want to be in the current financial climate is an outlier. then the markets will have you for breakfast. the truss-Kwarteng statement made us an outlier.

Instead of keeping their heads down, alone among the world’s major economies they announced huge unfunded cuts in taxes and increases in spending. No wonder the markets went for us. the run

on British bonds and sterling followed, as night follows day. It regularly baffles me how little free marketeers understand how free markets work.

Truss-Kwarteng plan to hold their nerve until the promised growth materialises. I’m not sure there’s an alternative. Equally, I’m not sure time is on their side.

Nobody knows when growth will return. We do know we face a major slowdown before it does, one made deeper and longer by the Government’s financial incompetence. And the worst pain is yet to come.

Yields on Government gilts understandably don’t mean much to most folk. But mortgage rates do and they are rising fast. The official base rate could now go to 5 or 6 per cent, pushed higher than it looked at the start of the month by the Truss-Kwarteng shenanigans. These higher rates could wipe out any gains from tax cuts, except for the very highly paid.

Lenders are required to test if borrowers can afford mortgage rates of the future expected base rate plus one percentage point; 7 per cent mortgages would put home ownership out of the reach for many.

Many existing mortgage holders would not be able to meet their monthly payments at that interest rate. The dismal prospect is of repossessions and a tanking housing market, with some experts forecasting a 15 per cent fall in house prices. High interest rates have already undermined the U.S. housing market.

Equally, many small businesses, still debt-ridden because of the pandemic, will be unable to afford higher rates on their loans. Bankruptcies beckon. A lower profits tax is irrelevant if you’re running up losses.

As well as misery for many, these are political timebombs under the Tories when Labour is already far ahead in the polls.

Financial crises have a habit of creating political watersheds. Labour never recovered from calling in the IMF in 1976 to bail out the economy. It led to defeat in 1979, Thatcherism and 18 years of Tory rule.

The Tories, in turn, never recovered from the shambles of Black Wednesday in 1992, when John Major’s government presided over the ignominious ousting of Britain from the European exchange-rate mechanism (a precursor of the European single currency). It was an especially brutal time for homeowners and small business, mostly Tory voters.

That led to 13 years of Labour government, until the Great Crash of 2008 contributed to the demise of Gordon Brown’s struggling administration in 2010. We’ve had various shades of Tory government ever since.

We will see if the financial crisis of the autumn of 2022 is of the same scale and political import of these previous crises. It is, as yet, too early to tell. But I sense it is.

As the Tory faithful gather in Birmingham this weekend for their annual conference they will be hoping that Kwarteng on Monday and Truss on Wednesday

Financial crises create political watersheds

Can the party conference steady the ship?

will produce speeches that steady the ship, calm the financial markets and give Tories a sense that all is not yet lost.

The omens are not encouraging. It is not clear what Kwarteng has left in his locker. Further unfunded tax cuts are, economically, out of the question. Major spending cuts are, politically, impossible for a weakened Government with fissiparous and grumpy backbenchers.

As for Truss, she will have to outperform all realistic expectations if she is to lead her Government and party out of the current morass. Her faltering round of radio interviews on Thursday did not inspire confidence.

During the Tory leadership contest I had cause to ask several times if Truss knew what she was talking about when it came to economic policy (though I was never allowed to put that question directly to her). Many might conclude that question has now been answered — definitively.