Bank of England
The Wealth of a Nation: Institutional Foundations of English Capitalism – review
In The Wealth of a Nation: Institutional Foundations of English Capitalism, Geoffrey Hodgson traces the roots of modern capitalism to financial and legal institutions established in England in the 17th and 18th centuries. Hodgson’s astute historical analysis foregrounds the alienability of property rights as a key condition of capitalism’s rise to supremacy, though it leaves questions around the social dimensions of the free market system unanswered, writes S M Amadae.
The Wealth of a Nation: Institutional Foundations of English Capitalism. Geoffrey M. Hodgson. Princeton University Press. 2024.
English capitalism was built on empire and slavery…State intervention and slavery are examples of impurities within capitalism. Impurities can be necessary or contingent for the system. Some state intervention was arguably necessary, but slavery was not. (13)
Countering conventional understandings of capitalism, Geoffrey Hodgson contends that “Secure property rights were not enough,” because “[m]ore wealth had to become alienable and usable as collateral for borrowing and financing investment” (119). Hodgson’s The Wealth of a Nation: Institutional Foundations of English Capitalism is a welcome contribution to heterodox economics that incorporates historical excavation and theoretical analysis to provide refreshing nuance to established accounts of the rise of capitalism. Hodgson provides historical details of Great Britain’s early modern property rights and finance institutions, building on his previous works and covering a dense corpus of theories and data going back to Adam Smith’s 1776 Wealth of Nations. Hodgson’s analysis of the financial origins of English capitalism focuses on types of property rights from 1689 to 1760 and varieties of financial credit supporting British industrialisation between 1760 and 1830. While readers can expect a perceptive analysis of the origins of British capitalism, they should not expect a critique of the social dimensions of the free market system.
The Wealth of a Nation […] incorporates historical excavation and theoretical analysis to provide refreshing nuance to established accounts of the rise of capitalism.
Part II, “Explaining England’s Economic Development,” including Chapter Three “Land, Law, War,” Chapter Four “From the Glorious to the Industrial Revolution,” and Chapter Five “Finance and Industrialization,” carries the brunt of Hodgson’s argumentation. Three aspects of the book stand out. The first is his overarching argument that the central institution enabling the rise of modern political economy in England was finance: the ability to alienate the ownership of land and other property to serve as collateral for investment loans. The second is Hodgson’s heterodox economic analysis emphasising historical contingency (as opposed to universal laws); Darwinian Variation, Selection, Replication (203-206); and the role of institutions. The third is Hodgson’s apparent embrace of capitalism. He celebrates the productive power of finance capital and industrial investment, but eschews a critical analysis of capitalism’s social consequences articulated by the likes of Karl Marx, John Maynard Keynes and Karl Polanyi.
[Hodgson] celebrates the productive power of finance capital and industrial investment, but eschews a critical analysis of capitalism’s social consequences
Hodgson engages the theories of Karl Marx, Douglass North and Barry Weingast and Deirdre McCloskey, criticising their arguments for being incomplete or flawed. Marx identified the exploitation of the working class by the bourgeoisie; he missed that changes in law preceded changes in the material base that ultimately consolidated bourgeois power. North and Weingast apprehend the importance of secure property rights but missed that these could encompass feudal property rights mandating primogeniture (oldest son inherits all property) and entailments rather than the new class of alienable property rights. McCloskey rightly focuses on ideas as a force for social evolution but misses the exigencies of paying for costly wars and the practical need for legal means to pay off sovereign debt.
The key underlying factor of the British Industrial Revolution from 1760-1830 was the ability to obtain finance.
Hodgson’s treatment is astute. The Dutch were leaders in public finance, and William III’s accession to the British throne in 1689 brought those practices into Britain (121). The period from 1689-1815 was one of “war capitalism” requiring that the state be efficient in raising taxes. The state gained the right to create money by decree, and debt itself could be sold along with contractual obligations to repay the debt. Hodgson dates the financial revolution to 1660-1760 (135) and associates the growing sovereign debt with the need to finance war efforts. The key underlying factor of the British Industrial Revolution from 1760-1830 was the ability to obtain finance. Hodgson challenges the conventional view that entrepreneurs obtained loans from family and friends. His argument rests on documenting that investors were able to stake collateral for their loans. He presents evidence on mortgages, such as for canals, and the rising ratio of capital existing as financial assets versus as physical assets. The British banking system had to adapt to offer credit for investment because the central bank was focused on financing sovereign debt for war efforts.
Hodgson redirects attention from the security of property rights to their alienability as the driving institutional invention critical for capitalism to emerge. Slaves represented a crucial category of this exchangeable type of property. Hodgson acknowledges that “By the end of the eighteenth century, slaves amounted to about a third of the capital value of all owned assets in the British Empire” (109). A sizeable category of alienable property in the early 18th century was that of slaves: £6.4 billion was land, buildings, animals, ships, equipment and other non-human assets, while £3 billion was slaves (2021 currency values, 149). Hodgson’s treatment of slaves’ contribution to the origins of what Adam Smith called the “system of natural liberty” is limited to their functional role as legally institutionalised property that could be alienated. Readers looking to heterodox economics to provide a critical stance on the origins of western free markets may seek more than Hodgson’s proposition that the institution of slavery was merely a contingent factor in the system’s rise. Hodgson acknowledges that the £20 million compensation paid to former slave owners for the 1833 Slavery Abolition Act stands as a historically unprecedented sum of liquid financial capital freely available for industrial investment in the 19th century.
The £20 million compensation paid to former slave owners for the 1833 Slavery Abolition Act stands as a historically unprecedented sum of liquid financial capital freely available for industrial investment in the 19th century.
In a twist of prevailing perception that the burden of debt is a form of bondage (eg David Graeber’s Debt, 2012), Hodgson frames indebtedness as the means of liberation to finance capital, which in turn drives economic growth. Hodson effectively defends Hernando De Soto’s property rights institutions to increase the welfare of the destitute by issuing land titles as a means to obtain credit. In a similar inversion of conventional sentiment, we can recall Adam Smith’s admonishment, counter to contemporary American libertarians, that tax, including poll tax, “is to the person who pays it a badge, not of slavery, but of liberty” because tax payers are subjects of government.
Hodgson adopts a Darwinian-inspired methodology based on variation, selection, and replication (the “V-S-R” system, 204). The section “Applying Darwinism to Scientific and Economic Evolution,” (206) is conjectural. He observes that, “Some individuals were more successful than others, affecting their chances of survival and procreation” (207). He rejects either a material account or a mental account of agency. The latter refers to “folk psychology” which attributes action to individuals’ desires and beliefs. Hodgson follows the school of thought holding that human action occurs before intention is conscious or rationalised (189-190). He holds that habits and dispositions, rather than deliberately formed intentions, govern action and form the bedrock of institutions.
[Hodgson] holds that habits and dispositions, rather than deliberately formed intentions, govern action and form the bedrock of institutions.
How, then, do we assess the merits of, or the underlying affirming conditions for, either the institution of slavery or alienable property and financial capital? Hodgson observes that,
People often obey laws out of respect for authority and justice, and not because they calculate advantages and disadvantages of compliance. Dispositions to respect authority have evolved over millions of years because they aided cohesion and survival of primate and human groups (201).
Hodgson’s argument that alienable property and appropriate financial institutions for investment were a condition for the rise of capitalism in Britain is convincing. However, without a clear conceptualisation of effective human agency, other than that driven by dispositions and habits, we are left with the stubborn question of the extent to which capitalist institutions are either emancipatory or the best means to better the human condition.
Note: This post gives the views of the author, and not the position of the LSE Review of Books blog, or of the London School of Economics and Political Science.
Image: The painting Coalbrookdale by Night by Philippe Jacques de Loutherbourg depicting the Bedlam furnaces at Coalbrookdale in Shropshire, England. Credit: The Science Museum, London.
Is UK monetary policy driving private housing rents?
Daniel Albuquerque and Jamie Lenney
Rent prices have risen by 9% on average in England since the Bank of England’s Monetary Policy Committee (MPC) started raising interest rates in December 2021. Alongside this rise in prices has been a widening in the gap between reported supply and demand in the rental sector, with tenant demand continuing to rise in 2023 amidst falling supply (RICS survey). Is monetary policy causing the rise in rents? In this post, we provide evidence that temporary increases in interest rates are ultimately associated with a decrease in rental prices that follows an initial, but relatively short lived, increase in rental prices and tenant demand. These results also hold across regions in England.
Rising rents and monetary policy
The recent rise in rents will be of significant concern to the 19% of households in the UK that are private renters, for whom housing costs already take up 33% of their income on average. Despite the fact that rising interest rates have been implemented to reduce overall price inflation, monetary policy has been cited as a possible cause of rising rental prices principally through two channels. First, the resulting increase in mortgage costs has consequences for both supply and demand in the rental market: it can discourage new buy-to-let landlords, and keep future homeowners as tenants for longer. Second, housing is an investable asset, and returns on other assets are rising due to the increase in interest rates. Thus, even non-mortgagor landlords are likely to increase rents in response to rising interest rates to match the expected return on other assets.
However, empirical evidence is mixed – in the US, for example, economists at the San Francisco Fed find that rents immediately decline in response to rising interest rates, while other work has documented increases in rental prices without a subsequent decline.
So is there any evidence that monetary policy is pushing up rental prices in the UK?
Estimating the causal effect of monetary policy on the rental market
In order to answer this question we use a local projections framework with 12 lags of the variable of interest as controls. We rely on monetary policy surprises identified in the 30-minute windows around MPC announcements to estimate the effect of monetary policy on rental prices, as described in more detail by Cesa-Bianchi et al (2020). We use unexpected changes (surprises) to identify the effect of monetary policy because most interest rate changes are made in response to current and future economic conditions. Simply using all interest rate changes would mix up the effect of interest rates on rental prices with the effects of other shocks that interest rates are trying to counteract.
For rental prices, we use data from ONS’s Index of Private Housing Rental Prices from 2005 to 2019, for England. We focus on England because data for the whole of the UK is available from 2015 only. We choose to end our data sample in 2019: we exclude the Covid pandemic period, because the relationship between monetary policy and rental prices may have changed during this time; and we have insufficient lags of data to make it worthwhile including data post-pandemic.
Chart 1 shows the estimated response of housing rents to a 1 percentage point rise in interest rates. The response for England as a whole is the dark blue line with the 1 standard deviation confidence interval shaded in blue. We also plot the point estimates for each English region in grey. The point estimates indicate rental prices rise by around 1% over the 12 months following a rise in interest rates. This result is replicated in most regions in England with the exception of the East Midlands, where the central estimate shows no rise in rents. Chart 1 also shows that after around 12 months this rise begins to dissipate, and by month 22 the point estimate is below zero in all regions.
Chart 1: The response of private rental prices to a 1 percentage point rise in interest rates
Note: The blue shaded region is the 1 standard deviation confidence interval for England.
Does the response of rental prices make sense?
As noted above, since housing is an asset, when real interest rates rise the real return on housing should ultimately also rise in line with other available returns. This real return can be achieved by either rising rents or falling house prices, or some combination of the two. Using the same local projections framework as in Chart 1, Panel A in Chart 2 shows that rental yields (rent divided by house price) do indeed rise in response to rising interest rates. Panel B decomposes this response in rental yields for England between movements in rental prices and movement in house prices (the latter is calculated as a residual).
Chart 2: Response of rental yields to a 1 percentage point rise in interest rates, and its decomposition between yield and house prices movements
Note: The blue shaded region is the 1 standard deviation confidence interval for England.
As Chart 2B shows, rental prices increase initially, in line with the increase in rental yields. However, our estimates suggest that most of the adjustment is coming from falling house prices, even though that adjustment is sluggish and takes almost a full year to materialise. As house prices are slow to adjust, this puts pressure on rents to rise at first in order for landlords to make adequate returns relative to their outside option ie selling and investing in other assets like government bonds. At the same time, we find that housing transactions fall in the year following the interest rate rise (Chart 4A uses the local projections frameworks from before on UK Land registry data for housing transactions). This slowdown in housing transactions can help explain a reduction in the supply of rental housing if selling landlords take their property off the rental market but struggle to find prospective buy-to-let landlords who, discouraged by rising mortgage rates, need house prices to fall further to make adequate returns.
Using survey data on the residential market provided by RICS and household panel data from Understanding Society we can also analyse the effect of monetary policy on tenant demand. Panel A in Chart 3 uses a similar framework as used in Chart 1 to plot the response of the reported net balances of changes in tenant demand in the rental market in the RICS survey. It shows that a rise in interest rates is initially associated with a rise in tenant demand that then dissipates after around a year. In Panel B, using individual panel data, we show that the estimated probability of home ownership falls for younger cohorts in the 12 months following a rise in interest rates. This helps to partially explain the rise in tenant demand through a delay in the transition from renting to owning.
Chart 3: Tenant demand after a 1 percentage point rise in interest rates
Note: The blue shaded regions are 1 standard deviation confidence intervals.
So initially rising interest rates could well cause pricing pressures in the rental market. However, over time house prices fall due to tighter monetary policy and enable new landlords to come in and offer lower rents. At the same time, households are likely to become increasingly unwilling to accept and afford rent increases as the effect of monetary policy on their real income builds. This gradual transmission of monetary policy to broader economic activity and incomes is illustrated in Panel B of Chart 4, which uses a similar framework to that of Cesa-Bianchi et al (2020) to show an estimate for the effect of a 1 percentage point rise in interest rates on GDP. Panel B shows GDP falling gradually with the peak impact occurring after around 12 months and persisting beyond that.
Chart 4: The gradual response of housing transactions and economic activity to a 1 percentage point rise in interest rates
Note: The blue shaded region is the the 1 standard deviation confidence interval.
Rental prices in context today
The causal effect of monetary policy in any given cycle is always difficult to disentangle from other broader shocks. This is especially true today with the UK in the midst of a broader inflationary shock, and still recovering from the longer-run economic effects of Covid that upended housing markets and migration flows. It is also worth noting that there have been changes in regulations affecting the rental market. These shocks are both directly and indirectly the underlying drivers of rising rents. Chart 5 plots the rise in private rents since December 2021 alongside the rise in average earnings and the level of CPI services. Both have tracked and indeed outgrown the rise in private rental prices, meaning that the relative cost of renting on average has not risen since interest rates started to increase. Compared to our results this is somewhat surprising, as our analysis would suggest rents could be growing faster than wages or other services now. However, other shocks to the UK’s labour market or cost pressures in specific sectors make it difficult to be definitive in this statement. Overall, through the lens of Chart 5, the pressures in the rental market seem to be consistent with the broader supply constraints in the economy.
Chart 5: Rental prices relative to incomes and other prices
Note: Prices are in levels and normalised to 100 at December 2021. Earnings are average weekly labour earnings.
Summing up
This post suggests that interest rate rises decrease rental prices in the long run, but that they may initially put pressure on the rental market. In our analysis, a temporary rise in interest rates leads to temporary increases in rental yields, as happens for returns on other assets in the economy. Tenant demand rises at first and landlord supply may be dampened by rising mortgage costs and slow adjustment of house prices. However, over time, our results indicate that the housing market should adjust, causing rental prices to decline.
Daniel Albuquerque and Jamie Lenney work in the Bank’s Monetary Policy and Outlook Division.
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Inflation as a tax
Last week I explored how Henry VIII resorted to coin debasement as a way to raise revenues in order to fight his wars. This provided Henry with the financial firepower to annex the city of Boulogne from the French in 1544, albeit at the price of England experiencing one of its greatest inflations ever.
Zoom forward five hundred years and Rishi Sunak, the Prime Minister of the UK, has ignited a controversy by referring to inflation as a tax, and further suggesting that the "best tax cut I can deliver for the British people is to halve inflation." His BBC interviewer disputed the claim, saying that inflation isn't a tax, a stance that the BBC upholds on its fact checking page.
Rishi Sunak, "The best taxt cut that I can deliver for the British people is to halve inflation."
Laura Kuenssberg, "Inflation is not a tax"
Rishi Sunak, "Inflation is a tax" pic.twitter.com/6LgMbeaprY
— Farrukh (@implausibleblog) October 1, 2023
If you recall, my previous article showed how Henry VIII's debasement functioned very much like a tax, say a new customs duty on wine or a beard tax. It did so by incentivizing people to flock to English mints to have their precious metals turned into coinage, Henry extracting a small fee on each coin. But the 21st century monetary system is very different from that of the middle ages. Is Rishi Sunak right to characterize inflation as a tax?
First, we need to better define our terms.
What do the BBC interviewer and Sunak mean by inflation? In the western world, prices have been rising at a regular pace of 2-3%
each year for decades as result of central bank policy, which targets a
low and steady inflation rate. Is this the definition they are using? Alternatively, Sunak and his interviewer may be referring to inflation as a *change in the change* in price. Since 2022 or so, that 2-3% rate has leapt to 8-9% all over the western world. Is it this jump that Sunak and his interviewer are talking about?
For the sake of this article, we'll assume that the conversation between Sunak and the BBC refers to the latter, a spike in the rate of inflation.
Secondly, what is meant by the word tax? Sometimes when we say that something is a tax we mean that it causes suffering. That is, inflation is taxing: it makes people's lives harder by increasing the cost of living, with salaries failing to keep up. It creates unfair changes in winners and losers.
Fair enough. But the more precise view I want to broach in this article is that inflation is actually a tax, where we define a tax as a formal charge or levy, set by the political process, that leads to cash flowing from the population to the government.
What does the data show?
Interestingly, a surprise jump in inflation leads to the very same effects as a new tax. All things staying the same, a new tax leads to an increase
in government revenues. This improves the government's fiscal balance,
or the difference between its revenues and expenses. A recent IMF paper by Daniel Garcia-Macia using data from 1962 to 2019 shows how an inflation shock typically achieves this exact same end result, boosting government revenues and improving its fiscal balance. This effect lasts for a few quarters, even up to two or three years, then recedes.
The IMF's chart below breaks down exactly how an inflation shock tends to improve government finances using quarterly data going back to 1999:
Charts source: IMF
Total tax revenue (the first panel) immediately begins to rise after the inflation shock at about the same rate as inflation.That's because most taxes are set by reference to values or prices, say like the prices of goods and services, or the price of labor, or the value of corporate profits. Since inflation pushes these amounts higher, this gets quickly reflected in tax revenues.
Income taxes and profits taxes (the second panel) rise particularly fast. Inflation is presumably pushing tax payers into higher income tax brackets, a process known as "bracket crreep," and so the government very quickly starts to collect a proportionally-larger amount of income tax.
Meanwhile, the government's total expenditures, the third panel, typically stay flat or only marginally rises in the quarters after the inflation shock hits. Notably, the amount of wages that are paid to government employees and social benefits (panels 4 & 8) tend to fall.
The net effect is an improvement in the government's fiscal balance. More specifically, for a 1% increase in inflation, the government's overall balance tends to improve by about 0.5% of GDP. And so an inflationary shock ends up at the same endpoint as a new tax: higher revenues and a better budget. That doesn't necessarily mean that inflation is itself a tax. Taxes have a degree of intentionality. They get implemented through a political process that has a certain set of goals in mind. By contrast, the extra revenue that an inflation shock raises is often (though not always) accidental, the result of external forces rather than political decision making.
So while it may not fall under the dictionary definition of a tax, the tax implications of a modern inflation shock resemble that of a new tax.
Everything I've written above applies to an inflation shock, say a rise from a 2-3% to 8-9%. Next I want to show that even constant 2-3% inflation can have the same revenue implication as a tax. Here's how.
Banknotes and seigniorage
Governments usually have a monopoly over the issuance of two key financial instruments: banknotes and settlement balances (also known as reserves). We all know what banknotes are, but what are settlement balances? Commercial banks find it useful to keep a stock of settlement balances on hand to make crucial large-value payments to other banks. The central bank, which the government controls, is the monopoly provider of these balances. (Sometimes banks are required by law to keep a a fixed number of settlement balances on hand, often above and beyond their day-to-day needs, a policy referred to as required reserves.)
Historically, interest rate on both types of central bank-issued money have been set at 0%. At the same time, the rates on short-term credit instruments (Treasury bills, commercial paper, bankers acceptances, etc) are determined by the market, typically hovering at a positive rate ranging between 0.25% to 5% over the last thirty years. These yields are priced to compensate investors for inflation.
The interest rate gap this gives rise to allows central banks to earn a steady stream of revenues, borrowing at an artificially cheap rate of 0% from both the banknote-using public and banks, and reinvesting at, say, 3%. Most of the revenues that the central bank collects from this interest margin flows back to the government. Economists usually refer to these revenue stream as seigniorage.
So seigniorage performs the same function as a consumption tax or an income tax: it takes resources from the public and gives it to the state. Likewise, a reduction in seigniorage would be very much like a tax cut.
If politicians wanted to, they could do away entirely with this form of raising government revenues. They have two ways of going about this. One way would be to have the central bank reduce price inflation to zero. By doing so, the interest rate on short-term credit instruments like Treasury bills would also fall to 0%, or thereabouts, since these instruments no longer need to compensate investors for inflation. And so the gap between the 0% rate at which central bank fund themselves and the rate at which they reinvest would cease to exist, seigniorage effectively shrinking to zero.
Over the last few decades, governments have taken a second route to removing seigniorage: they have begun to pay a market-linked yield on settlement balances. Canada, for instance, adopted this policy in 1999, and the Bank of England did so in 2006. By paying a market-based return, central banks no longer extract seigniorage from banks by forcing them to hold 0% assets.
However, that still leaves banknotes as a significant source of seigniorage. We can calculate how much the UK government roughly earns from banknote seigniorage. With £95 billion in banknotes outstanding in October, and interest rates at 5.1%, the Bank of England's banknote-related seigniorage comes out to around £5 billion per year, much of which flows back to the government. That sounds like a lot, but it's only a small chunk of the £790 billion in taxes the UK government collected last year.
Banknote seigniorage isn't set in stone. It's a policy choice. If governments wanted to, they could reduce this form of seigniorage by paying interest on banknotes. One way to go about this would be to introduce a banknote serial number lottery. This lottery would offer around £5 billion in cash prizes to holders of winning banknote serial numbers, equating to a 5% interest rate on banknotes. Doing so would be akin to enacting a tax cut on British citizens.
To sum up, the fact that both an inflation shock and steady 2-3% inflation have implications for government revenues suggests that while inflation may not quite qualify as a tax, it is certainly tax-like.
What was the real reason for the Bank of England's gilt market intervention?
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Why did the Bank of England intervene in the gilt market this week? The answer that has been doing the rounds is that it was protecting the solvency of pension funds. But this doesn't make sense to me. The Bank doesn't have any mandate to prevent pension funds going bust. And anyway, the type of pension fund that got into trouble isn't at meaningful risk of insolvency. There was never any risk to people's pensions.
I don't think the Bank was concerned about pension funds at all. I think it had a totally different type of financial institution in its sights.
Let's recap the sequence of events from a market perspective. This was, on the face of it, a classic market freeze. Pension funds sold assets, mainly long-dated gilts, to raise cash to meet margin calls on interest rate swaps (of which more shortly). The sudden influx of long gilts on to a market already spooked by an extremely foolish government policy announcement caused their price to crash. I am told that at one point, long gilts couldn't be priced - which means there were literally no buyers.
The crashing price of long gilts severely damaged the asset side of defined-benefit (DB) pension fund balance sheets. If these were normal companies, this might mean insolvency. But DB pension funds aren't normal companies. They are really the asset management arms of their sponsoring employers. As long as the employer is solvent, a DB pension fund can run with a substantial deficit - and some do, especially in the public sector, though this imposes an obligation on the employer to ensure the pension fund can meet its obligations over the longer term.
Anyway, the present value of DB pension fund liabilities falls as gilt yields rise. Since yield is the inverse of price, long gilts falling in price therefore poses no risk to the solvency of DB pension schemes. If anything it improves it.
So scary stories about pension fund "insolvency" entirely missed the point. DB pension funds were never at risk of insolvency. They were merely extremely illiquid. If you aren't clear on the difference between illiquidity and insolvency, read this.
DB pension funds try to minimise deficits, because as Toby explains, employers really don't like having to report wild swings in their DB pension obligations in their financial accounts:
"So if you, a board member of a company with loads of pension obligations, want to avoid reporting wild swings in your pensions funding status to both markets (in your reports and accounts) or the Pensions Regulator (and maybe have to submit a recovery plan, as well as pay a higher risk-based PPF levy), you want a pension scheme that aligns its assets with the way your liabilities are measured..."
Pension funds therefore aim to match the duration of their liabilities and assets as far as possible. And they use interest rate swaps to smooth out cashflows and perhaps make a bit of money from leverage. This is what "liability driven investment" (LDI) is all about. (I am oversimplifying quite a bit as this isn't a post about the workings of LDI, on which I don't pretend to be an expert.)
The way interest rate swaps work is key to this post. Pension funds that use derivatives have to post liquid assets (cash or cash equivalents) as collateral. The collateral must be sufficient to cover daily changes in the market price of the swaps (variation margin). Collateral insufficiency triggers a margin call, in response to which the fund must post more liquid collateral.
Pension funds that are trying to match assets with long-dated liabilities obviously won't hold much in the way of cash and cash equivalents. So when they receive margin calls they have to sell or pledge the most liquid of their assets to obtain cash. For sterling DB pension funds, that means long gilts. As Toby says, they hold lots and lots of them.
So when the long gilt market froze, DB pension funds couldn't raise enough cash to meet their margin calls. There was a real risk that they would default on them. This could trigger immediate liquidation of the collateral and unwinding of the swaps.
When swaps unwind because of missed margin calls, losses due to collateral insufficiency rebound to the counterparties - and the losses can be substantial. Who were these counterparties?
Well, they weren't LDI managers such as Blackrock. Those are just intermediaries. Some of them might have failed - or shut their doors, as Blackrock did - but that wouldn't have bothered the Bank of England. And nor would DB pension funds suffering mark-to-market losses on long gilts. That's a problem for their sponsoring corporations and perhaps the pensions regulator, not the Bank of England.
Yet the Bank of England was clearly worried enough to intervene directly in the long gilt market. It acted as buyer of last resort for long gilts, signalling that it would buy £65bn worth of the things over the next couple of weeks. This injected liquidity into the market, enabling pension funds to raise the cash they needed. It also incidentally set a floor under the long gilt price, limiting the damage to pension fund balance sheets.
But the Bank's action wasn't fundamentallly about ensuring the solvency of pension funds. It was intended to head off the threat of a systemic meltdown.
As mentioned before, pension funds hedge the difference between assets and liabilities with interest rate swaps. They have fixed liabilities and variable assets, so they want to swap fixed for floating rate (again I am simplifying - Toby has a more detailed explanation, op. cit.). So counterparties to these swaps must be institutions that want to swap floating rate for fixed. What type of institutions have floating-rate short-term liabilities but longer-term fixed-rate assets? Why, banks, of course.
So this is not a story about pension funds, it's about banks. The gilt market freeze was creating a cash collateral shortfall for pension funds, and as a result banks were at risk of serious losses on derivatives. We've seen this movie before and we know it ends with large quantities of blood on the floor. That's what the Bank of England feared. It intervened to stop the bleeding before it became a haemorrhage.
When you dig deeply enough into a financial crisis, you almost always find it's really about banks.
UPDATE: Thom Adcock on Twitter has pointed out that the interest rate swaps were likely to have been centrally cleared. If so, then the Bank of England was supporting clearing houses in much the same way that in the financial crisis the Fed supported AIG to prevent knock-on contagion to banks. A central swap clearer failing because of a gilts market freeze would have been a systemic catastrophe.
Further reading:
LDI: the better mousetrap that almost broke the UK - Financial Times
Pension funds and liquidity spirals - Critical Finance Blog
Image from Wikimedia Commons