In 1995, Nick Leeson, a 28-year-old trader for Barings Bank, brought down the City’s oldest finance house by, among other things, betting that the Bank of Japan (BoJ) couldn’t keep rates low after a financial crash led to a government borrowing spree. The devastating Kobe earthquake was the final blow. The BoJ cut rates, bond prices rose and his losses spiralled to $1.4bn. His failed gamble that markets would beat Japan sank Barings.
Barings’ collapse is perhaps a spectacular example of the “widowmaker” trade, where speculators think they can outsmart Japanese authorities. They’ve ended up with egg on their face as their gamble on Japan losing fiscal control proved misguided. Japan, with its own currency and a central bank working with the government, shows how the state shapes markets, not the other way round.
Britain seems to have forgotten this lesson with talk of “bond vigilantes”. True, the UK is very different from Japan. But in economic terms there are similarities: both borrow in their own currency; both have floating exchange rates; both are net importers of food and fuel, leaving them vulnerable to imported inflation. Yet only one has built a resilient economic model around these facts. And it isn’t Britain.
Sterling’s recent drop has made headlines. But its long-term value, as economist John T Harvey points out, is determined by foreign exchange trading. In the case of the pound and the yen, foreign exchange turnover exceeds trade by more than 100 times. However, interest rates, unemployment, inflation and trade flows are indicators that determine short-term currency prices disproportionately because whatever traders think is true becomes fact as it then moves the market. As George Soros noted, traders’ perceptions matter, and are driven less by facts than by whether the City regards the government as competent.
That insight should liberate policy. The UK can and should run fiscal deficits to fund a green industrial strategy – investing in domestic manufacturing, energy security and a strong export base. Investing in industrial capacity and public goods strengthens the economy, helps reduce inequalities and reduces vulnerability over time.
It would also address the UK’s persistent current account deficit. Britain imports more than it exports – and this deficit, by necessity of accounting, is offset by capital inflows, not because they fund government spending. The upshot is Japan is a net capital exporter, while the UK has become addicted to short-term inflows into property, financial instruments, and speculative assets – flows that can reverse sharply, as seen in the 2022 gilt crisis.
Which brings us to Liz Truss. Her downfall wasn’t caused by borrowing per se, but by doing it for the wrong reasons. Sacking Treasury officials, bypassing institutional safeguards and promising unfunded tax cuts for the wealthy during a bout of high inflation showed not boldness, but a breakdown in basic statecraft. It wasn’t a macroeconomic crisis but a governance crisis.
Rachel Reeves risks a different mistake: adopting fiscal rules to appease markets but that ignore reality. Rather than the self-imposed arbitrary constraints, which she already changed last October, the Labour party should be bold and get rid of them altogether. Better the budget features a short statement of how government plans will affect the economy – on trade, inflation and investment. It should be voters, not markets, who decide what’s credible.
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