Same Fate as the Frog?

The boiling frog is an apologue describing how to boil a live frog.

The premise is that if a frog is put into water that is already unbearably hot, it has the sense to jump straight back out,

However if you put the same frog into lukewarm water it will find it quite pleasant and not notice as you raise the water temperature until its too late to respond - having failed to perceive the danger of the slowly rising temperature it will stay put – ultimately being overtaken by the effects of the temperature and finally being slowly cooked to death.

Not a pleasant proposition. But, swap the frog for the British public and the slowly heating water for our present economic situation and it is one that is illustrative of our current state of financial woe. Substitute the frog for a mortgage payer potential house buyer or any other person exposed to the need to take on new debt who is used to paying the low rates of recent years and you see the need to realise the water temperature is rising – rising very rapidly.

Listen to the media and twitter sphere and its easy to think this is a sudden problem wholly due to the swivel eyed free market beliefs and cack handed delivery of our new PM and Chancellor.

Listen to the opposition parties and you would be drawn to a belief that the answer is simply to revert to the old policies and tax the rich and large corporations to provide the money needed to deliver salvation.

Reality?

It is true that the Truss / Kwarteng strategy for growth requires separation of governments fiscal policy from the monetary policy actions of the Bank of England and so has an obvious consequence in rising interest rates and adding complexity to controlling inflation – especially without clear buy in from the Bank of England and support of the money markets they rely on.

It is also true that they have been unbelievably poor, if not plain stupid, in the way they have acted in bringing forward and communicating their plans. Its safe to say that this has resulted in their ambitions, good and bad, been received with all the enthusiasm of a diner presented with a bowl of sick.

But, I don’t believe it is that simple, "Its all Truss’s fault" is an easy narrative to peddle but the reality is that this is a storm that has been building across the whole world for some time and that has been given hurricane force and brought quickly to shore in the UK by a mixture of events and circumstance;

All explosions need two things to go "BANG"

Firstly the explosive charge that does the damage - the long approaching day of reckoning for the debt, borrowings and inflationary pressure that has been built up worldwide during the COVID pandemic. These are bills whose origin lies in the extraordinary fiscal measures taken by Government. Measures that were supported by all political parties so none can recile from responsibility for the results. These are measures that were always destained to have huge implications for the UK’s public finances having driven a surge in government borrowing and debt never seen outside a world war and created public belief in a continuing supply of cheap and easy finance and the Government’s ability to magic away the very real problems that had been created by over two years suspense of economic reality.

Secondly the detonator - the thing that initiates the explosion here the sudden rise in the economic temperature has provided the explosive mix of hot air and combustible fuel necessary to create the explosion. This has been delivered by the disruptions caused by the Russian invasion of Ukraine now compunded by an unexpected and uncosted handbrake change of fiscal policy instigated by our new executive, without first securing the buy in of the financial markets. A change of direction that has abruptly broken from what had become the established orthodoxy of the political classes. This detonator sparked uncertainty and a huge media own goal, opening the space for opponents to make hay and financial market players the chance of a killing from the volatility of the UK £ exchange rate.

The sudden negativities within the finacial sector have also brought to the surface yet another appearance of the problem of financial derivative models failing – this time exposing serious vulnerabilities in elements of the so-called shadow banking sector and companies that control many trillions of £s worth of our, the working populations, assets.

Specifically Companies within the Pensions Industry.

Companies in this basket include the likes of; insurers, investment firms and pension funds. These companies are not subject to the same regulatory rules as traditional banks. This is particularly important when it comes to requirements to hold liquidity (fast access to cash) to protect against market shocks of the type experienced by the banking sector in 2008. The problem here is that pension funds hold very long term commitments to pay out pensions to many millions of individuals – they make long terms investments to be sure that they have enough assets that can grow in value to meet these long term liabilities but they also need a constant supply of real money (cash) to pay current pensioners.

This requires a balancing act between having money to pay for today and safe growing assets to meet future years commitments and once again the Oh too cleaver methods that these companies use to present a solid appearance of financial prudence and solvency (whilst generating £000,000s in commissions and fees within the financial sector) have been based in the construction of complex financial products that one part of the financial industry can sell to an other to give an answer and stability that actually does not comprise “money in the bank account” .

Enter LDIs , “Liability Driven Investments”. Basically a bet on the steady pricing and yield of Government Bond values. As with the bet on the solvency of investment vehicles based on bundling up retail mortgages that the offering company had no control over but believed (bet) would not default - the MBDs "Mortgage Backed Derivatives" a type of collateralised debt obligation that crashed so spectaularly in 2008 - once again the stress models of these mathematical wonders have proven to end not in a gental ringing of an alarm in the ear of the holder but a drop off a high cliff and spiral into a self perpetuating doom loop towards disaster.

All that is needed is a perfectly predictable event to occur with sufficient force and rapidity.

In 2008 it was the widespread default of individual mortgage holders that punched a hole in the MBD boat. This time it is a rapid increase in interest rates v value of gilts that has, as with 2008, see the triggering of a major danger to stability that could only be addresed by government interventions and a central bank bailout [in the UK by the Bank of England], this time to stave off a melt down in what most people think of as the steady and safe UK pension industry.

A quick explanation

This situation has quite a way to run – the UK is far from unique and also not the worst impacted economy in terms of borrowings, inflation and core interest rates, take a look at the EU, Japan and the USA. Worldwide the water temperature, measured in retail interest rates and inflation, is on the rise and it is going to become very hot indeed. For many who have taken the recent years of exceptionally low interest rates and low inflation as the new normal and surity they need to to buy a bigger house, new car etc, by gearing their borrowings to the limits of their income the unfortunate fact is it will be too hot to stay in the pan.

Like the frog in the apologue its important to understand the consequences of the rises in temperature happening around them and hop out of the water in time.