U.K. Provides World Valuable Lesson in Unintended Consequences
By Murray Leith
CFA, Executive Vice President & Director, Investment Research
Monday, October 03, 2022
Something big happened in the world of finance this week, yet many will not have noticed. U.K. defined benefit pension plans were on the brink of insolvency following a revolt in the market for U.K. bonds.
At the beginning of last week, the U.K.’s equivalent of Canada’s Minister of Finance, Chancellor Kwasi Kwarteng, proposed a plan to boost the economy by cutting taxes and borrowing lots of pounds to cover the increased budget deficit that would result. Stimulating the economy fiscally via unfunded tax cuts is at odds with the Bank of England’s effort to tame inflation, which is currently running at an annual rate of close to 10%.
The market’s reaction was harsh and sudden. U.K. bond prices cratered, producing record-breaking rises in yields on U.K. gilts, and the value of the pound got pounded, reaching a record low.
Amidst the chaos, the Bank of England was forced to step in to calm the situation, and say that it would buy as much government debt as necessary to stabilize the bond market. They succeeded; the pound rallied off its low, and gilt yields retreated.
Still, there are lessons to be learned from the U.K. experience.
The first is to appreciate that the currency and bond market volatility was not merely the consequence of a misguided and counterproductive government initiative to lower taxes in an economy facing significant inflation. Rather, it was the unintended consequence of years and years of monetary mismanagement.
Following the 2008/09 Great Financial Crisis, the world’s major central banks, including the Bank of England, manipulated interest rates to keep them ultra low, and printed lots of money, by buying government bonds in so-called quantitative easing operations. While the policies were well intentioned and designed to create jobs and stimulate economic growth, they were also recklessly pursued without regard to longer-term negative consequences.
Inflation is the most obvious adverse ramification of excessive monetary accommodation. The other main ones are: (1) excessive risk taking and increased financial leverage, which undermine the stability of our economic foundation; (2) misallocation of resources, which undermines productivity; and (3) asset inflation that disproportionately benefits the rich, which in turn fuels inequality and social unrest.
U.K. defined benefit pension plans were on the precipice of demise because the managers of the funds took greater risks to meet the retirement claims of pensioners. Pension funds have long-term liabilities that are most conservatively hedged with long-term bonds. But when interest rates are kept artificially low by central banks, it gets tough to achieve return objectives with a conservative portfolio. As such, the U.K. fund managers used leverage and risky interest rate derivatives to enhance returns.
When U.K. interest rates began to rise dramatically following the tax cut announcement, the pension funds received margin calls on their risky derivative contracts. They were forced to sell bonds, and other assets, to meet the increased collateral requirements. The act of selling bonds put further upward pressure on bond yields, fueling additional margin calls in what came to be termed a “doom” loop. Fortunately, for now, the Bank of England arrested the self-fulfilling process by stepping in to buy bonds.
In our opinion, the U.K. pension crisis was the consequence of years of overly accommodative monetary policies which encouraged excessive risk taking and increased leverage in society.
It exposed the fragility of the financial system, and that is indeed scary. But it also provided the world’s leaders and central bankers with an important lesson in the unintended consequences of monetary mismanagement.
We are optimistic that lessons will be learned and that policy, both fiscal and monetary, will be better.