Citizens all over the world gathered around to witness the horrors of what had unfolded behind closed curtains, the oldest currency had fallen to an all time low. In just a matter of under two weeks the pound fell 11.7% from $1.17 to $1.035, increasing inflation even further. UK 30 year bonds (known as gilts) dropped 45% during this time as businesses and pension funds panicked and created the largest sell off of gilts in a single day.
This event is being compared to what happened in the US for the 2008 housing crisis where the Lehman Brothers investment bank filed for bankruptcy which was the catalyst for the whole crash in the first place. In this case, pension funds were nearing bankruptcy which caused many peoples retirement funds to be at risk, if not for the government stepping in, there could have been a worse event that may have materialized.
Pension funds need to pay their customers a fixed amount of money no matter what economic situation the country is going through. Because of this fixed amount, pension funds usually buy bonds in order to offset their liabilities of paying the fixed amount to their pensioners, so they’re able to have enough assets to cover this payment. The problem started with continuous low interest rates after the coming of COVID-19, these low interest rates made it so pension funds couldn’t pay back their customers a fixed amount because they weren’t generating enough interest themselves from bonds. To pay this fixed amount, pension funds got desperate and invested in young companies that had a lot of potential so they can sell at a profit and be able to pay their customers back using derivatives. The pension funds tried to hedge their bet using leveraged investments (borrowed money from banks) which are subjected to margin calls, telling the investor that they could get liquidated and lose all their money because the banks themselves don’t want to lose money from their investment.
These pension funds were forced to sell off a lot of their gilts in order to not get liquidated and add on to their derivatives gamble which caused the gilt market to take a huge stumble down. If the pension funds were to let their derivative trades get liquidated they could face insolvency and go bankrupt so there wasn’t much room that these funds had to work with. With no one buying gilts, the government was forced to intervene and buy up 65 billion pounds worth of gilts that were being sold to stop the crash of the economy.
Instead of the government continuing with quantitative tightening which is the process of the governments selling gilts on the open market and getting rid of money circulating from the public in order to battle inflation, its hand was forced to require quantitative easing. With the buying of gilts to ease the economy comes bad and hefty long term implications for the economy. For one, this will only continue the rise of inflation and give banks a tougher time to catch up on interest rates to lower inflation down.
The Bank of England declared that it expects the UK to be in a recession (the situation with the pension funds only sped this process). UK’s prime minister Liz Truss announced that the government would freeze energy prices for households for about two years, costing the government 89 billion pounds. The energy will be funded through government bonds which at a time like isn’t the best option, this is because borrowing gilts while trying to bring inflation down will increase debt due to companies losing money from interest rates. More borrowing at a time of burgeoning debt isn’t good for an economy in the long run.
It also didn’t help that the government announced that they would cut taxes for the rich in order to stimulate the economy and then last minute reverse their decision to do so. Decreasing taxes for the rich may restore prices in the economy but it isn’t a popular option among the people, therefore this caused for a reversal in decision. It seems as if the government doesn’t know what the correct course of action should be leaving citizens in distress and uncertainty.
