Labour is walking a fiscal tightrope

The prime minister has prepared the public for Labour’s first budget on Wednesday by promising to “embrace the harsh light of fiscal reality”. As has been clear for the past three months, the government is walking a fiscal tightrope, caught between the need to improve underfunded public services and reverse decades of underinvestment, and a parlous set of public finances and voters that are resistant to further tax rises.
“We’re not going to continue the fiction, the pretence that you can always have lower taxes and run your public services properly — it’s completely and utterly untrue,” Sir Keir Starmer said in a speech on Monday.
Labour’s narrow path will be encapsulated in a new fiscal framework unveiled by Rachel Reeves in the Commons on Wednesday. The chancellor will announce that the government will be bound by a “stability rule” to fund its day-to-day spending — like public-sector pay awards and ministerial expenditure — with money generated by tax revenues.
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The rule was first introduced by Reeves’s predecessor, Jeremy Hunt, and is currently measured over a five-year period. Reeves could shrink this to three years to prove her frugal mettle to financial markets. The stability rule will become the main binding constraint on the government’s spending plans and will force Reeves to find about £40 billion in tax rises and expenditure cuts to hit the target.
The second part of Labour’s fiscal framework will be an investment rule that transforms the current target to reduce the government debt over a rolling five-year period. Reeves will adopt a new measure of the national debt known as “public sector net financial liabilities” as a percentage of GDP, a move that will magic up £50 billion a year in extra borrowing space. Of this, she will tap only about £20 billion to £25 billion annually to fund investment in clean tech, infrastructure and the digital economy — projects that are meant to deliver a return to the taxpayer. In effect, it will mean that Labour will have reintroduced a watered down version of its promise for £28 billion in green investment, a pledge it was forced to abandon earlier this year under Tory pressure.
But to prove herself more frugal than the Conservatives, Reeves is also considering tightening the debt rule so it has to be hit in the fifth year of the Office for Budget Responsibility’s forecast, rather than the current rolling period, which, in practice, is never met. This has been central to the “fiscal fiction” that the OBR has hit out at over the past two years.
With this intricate balancing act — which involves loosening the fiscal strictures on investment but tightening the screw on short-run spending — Labour is hoping to appease a number of constituencies. They include voters who demand a better quality of public services, a business community that Labour has successfully schmoozed since the nadir of the Corbyn years, and most immediately, the band of bond vigilantes that bought down Liz Truss just over two years ago.
By binding herself to a strict deficit reduction rule and maintaining a healthy £30 billion in breathing room against her debt target, Reeves is hoping to keep the bond vigilantes at bay. It’s also why she announced her new fiscal framework a week in advance at the International Monetary Fund’s annual meetings to give bondholders time to digest the changes. To be forewarned is to be forearmed, a maxim that Truss had little truck with.
Under Labour, the UK is embarking on a unique experiment to resolve a fiscal predicament that most advanced world economies are grappling with. Reeves’s plans were met with interest by her fellow finance ministers in Washington last week and won the backing of senior officials inside the IMF as a sensible response to the UK’s chronic economic weaknesses.
The chancellor took comfort from the endorsement but will have been less enthused by the fate of some of her political allies. Chief among them is Janet Yellen, the US Treasury secretary and lodestar for Reeves, who has consistently pointed to the Biden administration as an inspiration for Labour’s economic philosophy. For the past four years, the Democrats’ response to years of underinvestment and weak growth has been mass deficit spending to stimulate and re-industrialise the American economy at the expense of China and its trading partners.
This is not a route the UK can afford to go down in terms of borrowing splurges or tariffs, leading Labour to quietly drop its effusive endorsement of Bidenomics since taking office. Instead, government staffers have spent the past few months reading up on an influential essay — The Death of Deliverism — on why Biden’s progressive economics has failed to secure a clear route to re-election.
Finance ministers on the right of Reeves are faring no better. Her newly appointed French counterpart has been forced to announce brutal and unrealistic austerity measures worth €60 billion next year to shrink a ballooning budget deficit. By contrast, Christian Lindner, Germany’s frugal finance minister, has refused to turn on the spending taps to revive a recession-hit economy and is clinging to harmful budgetary strictures. Italy’s hard-right government is carrying out consolidation but with a debt ratio on course to grow to 138 per cent of GDP in the coming years. Canada’s liberal government is also on course to get the boot next year, with voters suffering from punishing mortgage rates since the pandemic.
The comparisons are instructive for Labour, who want to avoid the pitfalls of Biden’s Democrats or Justin Trudeau’s Canadian Liberals. They are also useful for gilt holders that are weighing up how the UK’s economic quagmire stacks up against its neighbours. The yield premium on gilts has crept up over German and French bonds in the last week, a reaction to an expected increased debt issuance next year. But leading investors are more sanguine. Pimco, one of the world’s largest bond funds, says Labour’s changes are “unlikely to undermine fiscal credibility”. The verdict, whatever it is, will be known very soon.
Mehreen Khan is Economics Editor of The Times