Liz Truss and Giorgia Meloni, two new Prime Ministers (one pending) facing the squalls of the bond market, should heed the advice of Jacques de Larosière, sage of European central bankers. In a new book on the perils of financialization, the former governor of the Banque de France and managing director of the International Monetary Fund blames years of “systematically accommodative” monetary policy for having “a hyper-indebted financial system vulnerable to crises”.
Both Truss and Meloni won victories – one in the UK over his Tory leadership rivals, the other in the general election in Italy – within three weeks of each other. Both politicians face a backlash from financial markets that encourage excessive borrowing when interest rates are abnormally low. As de Larosière writes, illusions of comfort are inevitably shattered when financial conditions deteriorate.
Truss is plagued by the Conservative Party’s self-inflicted difficulties: inept execution of the withdrawal from the European Union and failure to heed the lessons of common sense and history regarding the fights with the financial markets. Italy’s woes have even deeper roots, reflecting the failure to achieve anything like adequate economic growth over a 30-year period before and after joining monetary union.
In his first statements promising “responsibility” after his election victory, Meloni, leader of Italy’s far-right Brothers of Italy party, seemed more attuned to market sensitivities. By contrast, Kwasi Kwarteng, Truss’ Chancellor of the Exchequer, ignored grave internal warnings that his calamitously received September 23 tax package could provoke a negative financial market reaction. The result was a collapse in sterling, government bond prices and the Conservative party’s residual reputation for economic competence.
Meloni has not yet endured his baptism of fire. His first battles with the markets could come soon after his expected appointment as prime minister next month. The sharp rise in spreads (between 2.4 and 2.5 percentage points) between German and Italian 10-year government bonds gives a taste of the problems ahead.
The widening of the spread represented market forces as the European Central Bank did not intervene to support the bond prices of the most indebted member countries. The ECB intervened significantly to support Italian and Spanish bond prices in July as part of a flexible reinvestment of maturing bonds in its “pandemic” portfolio. But these additional spread-shrinking purchases have come to a halt over the past month.
Irritating to populist politicians who wish to show they are in charge, the immediate future of Truss and Meloni hinges on the actions of unelected central bankers.
The Bank of England’s bond market intervention announced on September 28 averted a predicted collapse in the UK pension fund sector threatened by an unprecedented rise in government bond yields. Bank Governor Andrew Bailey redeemed his promise (made at an OMFIF meeting on July 12) to change course on planned government bond sales in the event of market distress.
Yet by announcing £65bn of 13-day government bond purchases amid rising interest rates, he contradicts his commitment at this meeting to align all of the Bank’s monetary tools in the same way. Maybe he politely tells Truss she has 13 days to get another Chancellor.
Bailey was attacked for alleged inflation recklessness during Truss’s leadership campaign. After his inaugural misjudgments – including the fanciful sacking of Tom Scholar, the permanent secretary of the Treasury – losing a Bank Governor would seem too reckless. Despite past mishaps, Bailey’s position is much more secure than a month ago.
Meloni’s course in economic policy – and his ability to make good campaign promises (especially by right-wing coalition allies) on taxation and spending – will be heavily influenced by the ECB’s action to shore up Italy’s debt. . The ECB council faction in favor of monetary tightening has won support for further interest rate hikes thanks to the complicated bargain of agreeing a “transmission protection instrument” to potentially support the bonds of the weakest members of the euro.
Still, important details about the TPI were left unspecified, including whether (as is likely) the Banca d’Italia would be called upon to substantially assume the risks in the event of an Italian bond intervention. A September 26 statement to the European Parliament by ECB President Christine Lagarde ruling out the intervention of a new Roman government to correct “political errors”, confirms the impression that the ECB is very reluctant to implement the program.
The Truss government’s misfortunes outside the EU have continent-wide ramifications. European central bankers view the decline of the pound as a welcome factor helping to curb any planned economic excesses by Meloni. Members of the Governing Council who are hesitant to reduce the ECB’s balance sheet will be reassured by the Bank of England’s about-face on quantitative tightening. This increases the difficulties faced by some central banks to put QT on the ECB’s agenda next month. However, some quarters are still determined to start reducing the ECB’s bloated balance sheet as soon as possible.
There are intriguing parallels with a landmark in British EU history: the Black Wednesday departure of the pound from the European exchange rate mechanism 30 years ago. Truss and his team have generally failed to heed some basic lessons.
On September 16, 1992, Italy and the United Kingdom left the ERM. Italy returned four years later (ready to join the euro in 1999). The UK is gone for good. Italian politicians ceded ERM membership without a fight, once the Bundesbank said it would no longer support the lira. In August-September 1992, the British Treasury thought it could conquer the markets and win. The illusion of British exceptionalism has hopelessly peeled off, just as it has now. As in 1992, it will take years for the Conservative Party to pick up the pieces. The economic misadventures of the conservative party pave the way for electoral defeats.
David Marsh is President of the OMFIF.
Jacques de Larosière, Ending the Reign of Financial Illusion: For Real Growth, Odile Jacob, Paris (2022)