Do the financial markets have too much power?

This is power – raw, brutal power. The financial markets have forced the government of the world’s fifth or sixth largest economy to sack its finance minister and will almost certainly force it to sack its prime minister in the coming weeks. It does not matter that the Tories still have a huge majority in parliament, or that Liz Truss was elected by her party members to be PM. The game is over.

We know why. The markets thought that the financial programme of the government was not credible. It involved borrowing a lot more money and doing so without the discipline of having its plans assessed by the watchdog set up to scrutinise them – the Office for Budget Responsibility.

Lending to the government was seen as more risky, and as we all know, borrowers with poor credit ratings have to pay higher interest rates. Bond yields shot up, which had the effect of increasing the cost to all sterling borrowers including UK home-buyers. And that forced the retreat.

For many people, this will be a relief. Sound money is being forced on the government. For opposition supporters, it will be more than a relief because it greatly increases the chances that Labour will lead the next government. Voters find it hard to forgive financial incompetence on such a massive scale, especially if it hits their own personal finances too.

But we need to think about the power of the markets, because an amorphous body of people has, in effect, overthrown an elected government, and we know from the banking crash of 2008 that these markets can make spectacular mistakes themselves. So what are they?

Let’s start with the bond markets. Bond buyers are any and every person or savings institution that buys or holds fixed-interest securities, but in practice, this is a market dominated by American money. James Carville, political adviser to Bill Clinton when he was running for president, famously observed: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope, or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

That was in the early 1990s, when even the US government had to pay attention to long-term interest rates. There have been other times in relatively recent history when the bond markets exerted their power. During the eurozone crisis in 2011, the fact that several countries, notably Greece but also Spain, Italy and Ireland, could not borrow at acceptable rates forced them to cut wages and public spending. Many people lost their jobs, with unemployment in Spain reaching 27 per cent in early 2013.

But then power switched. The policies of the central banks to cut short-term interest rates to near zero (and make them negative in Europe) and to pump money into the financial system through “quantitative easing” reduced bond yields worldwide. For the best part of a decade the markets lost their power.

Now they have it back, and as before, it is US financial institutions that are the most important players in this show. Within Europe, the various national savings bodies are more important, for American buyers are not substantial buyers of euro-denominated securities. But they set the tone in the UK, either buying the debt or, as in recent weeks, selling it.

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We will see what happens this week, but on Friday, 10-year UK government securities, also known as gilts, were trading at a little under 4.4 per cent. The equivalent US bonds, 10-year treasuries, were just over 4 per cent. So the market’s judgement is that it will charge the US government about 0.3 per cent less on a 10-year loan than it will the UK government. Rates for all governments have risen this year very swiftly, but back in the summer, when Rishi Sunak was still chancellor, the UK could borrow more cheaply than the US. Now it can’t.

As you can see, markets are capricious. Is their power justified? That is a tough one to answer in any satisfactory way. The best response I can give is to say that if governments run sound financial policies, then they will find investors queuing up to lend them money. Those policies are well established and were encapsulated in Gordon Brown’s “golden rule” that a government should only borrow to invest, not to finance current spending, over the economic cycle.

The problem comes with the interpretation. In the end, it turned out that Brown had failed to stick to his own rule, which was why George Osborne, the then chancellor, set up the Office for Budget Responsibility in 2010 as an independent watchdog.

But it is an imperfect world. Markets make mistakes. They are subject to investment fashions and those change. There is a herd instinct so that when they stampede, governments get trampled underfoot. And that is exactly what has happened in the past three weeks.