Merlin Weekly Macro: The rehabilitation of The Iron Lady

The miraculous rehabilitation of The Iron Lady.

It’s a modern political miracle. She was cast as a pariah, virtually in league with the devil, by Labour and the broader Left for two generations. She was quietly parked on the outer fringes of memory as a historical embarrassment by a sizeable chunk of the parliamentary Conservative party from the day they kicked her out. Suddenly everyone wants to be imbued with the spirit of Margaret Thatcher. All the candidates in the Tory leadership election in 2022 invoked her name to burnish their own credentials as her spiritual heirs; mere minnows by comparison, they appeared deluded then and are demonstrably so now. Today, Labour’s Keir Starmer and Rachel Reeves, half of Starmer’s new Quadrumvirate Politburo, even if not agreeing with Thatcher’s policies, have made clear their admiration for her political courage and their aspiration to emulate her conviction leadership; time will tell whether they are worthy of the favourable comparison.

Reeves conflates Thatcher and Brown: unlikely political bedfellows

This week, comparing today’s economic plight with that of 1979 when Thatcher took office, Shadow Chancellor Rachel Reeves has been speaking of the need to restore fiscal responsibility. As if drawing on the legacy of ‘The Iron Lady’ is not enough, donning the cloak of another dominant political figure from the days of yore, Labour’s Gordon Brown, Reeves aims to follow his fiscal rule when Chancellor of only “borrowing to invest”. Brown’s “Prudence” in 1997 and his plan to stick within the limits of the previous Tory government spending plans seems to be a powerful draw for his potential successor.

Pity that Brown’s fiscal discipline didn’t last very long. Prudence quickly dispensed with her modesty when, from 1998 government deficits began to grow from close to zero to a stable but persistent 2% of GDP before blowing out to 4% when the Global Financial Crisis hit in 2008. Debt/GDP was a manageable 30% in 1997 but fuelled by those recurring deficits, the ratio began to climb into the mid-30% range, clearly on a gradual upward trajectory and eventually doubling to 70% by the time Labour left office in 2010. If 30-odd% sounded a good result during those early years, reality proved the debt/GDP ratio increasingly to be a work of financial fiction: a fan of Private Finance Initiatives (PFI), Brown extensively used public-private financing constructs for both public sector capital projects and operating contracts designed specifically simultaneously to draw in private sector financing into the public arena on the one hand and to allow him to remove such financing from the government balance sheet on the other. As it later emerged, notably in the education and health sectors, both big users of PFI, with badly written contracts substantially favouring the PFI operators, the real costs were egregious and the service habitually far short of what was promised. Brown’s signal crime (among others including comprehensively wrecking the UK pension system), however, was not only failing to keep something by for a rainy day but selling more than half our national gold reserves in a programme which began in May 1999 and ended in July 2002, netting around $3.5billion (he sold at the lowest prices recorded since 1979 and they have been persistently higher ever since he finished the disposal; today those 400 tonnes he virtually gave away would be worth around $28 billion)

Reeves’s fiscal principle is superficially sensible and sound: day-to-day public operating expenditure will be funded by revenue receipts (i.e. tax) while “investments” will be met by borrowings. If only the distinction between operating and capital expenditure were so binary. All too often, both the Treasury and the government’s spending departments confuse the two. As if not bad enough, particularly when under political pressure to spend and if the government revenues fail to cover the day-to-day outgoings, the temptation simply to cover the shortfall with borrowings is difficult to resist, the more so when interest rates come down again

The “Alice Conundrum”

Reeves faces four significant challenges. The first is the OBR rule which says that government debt must fall by the fifth year of any fiscal plan (perversely, the fifth year is always unattainable because the period is a perpetually rolling one rather than fixed; by logical extension, because it can never be hit, neither can it be missed!); the second is growth: she might be able to exercise influence over it but she does not control it; the third is political: can she resist the significant pressure from the Left and their firm preconception of “14 years of Tory mismanagement and cuts”, to spend significant sums; finally, the fourth is one of her own making: her determination to be the “Green Chancellor”, the progenitor of the UK as the “Green Power House”, despite already having got her sums embarrassingly wrong under her flagship plan labelled “Securonomics”.

You may remember the scene in Lewis Carroll’s Alice Through the Looking Glass in which Alice meets the Red Queen. Alice cannot understand how in this strange world through the mirror, however fast she runs, she gets nowhere; to which the Red Queen replies, “A slow sort of country! Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”

To balance the books and to avoid burgeoning deficits, Reeves needs the economy to run faster than ever to generate the tax revenues to meet the spending requirements. Quarter of a century ago, Brown’s budget deficits became a fiscal fixture despite the economy enjoying a purple patch with growth averaging 2% for much of the period before the GFC.

Reeves will inherit the highest tax burden since the Second World War, and close to the highest level of debt/GDP in history, and the current government deficit is 5.6% of GDP. If she fails to stimulate consistent growth at above the pedestrian rates seen for most of the past decade and more, eventually the elastic band will snap. For all the complexity of her job, at its most fundamental, she only has two levers at her disposal: how much tax revenue she raises and how much she allows the government to spend. In the event the two do not balance, she will be forced either to make significant spending cuts or raise taxes. The former is a political no-go area: Labour voters do not habitually vote in a Labour government to enact swingeing public sector cuts. The latter is self-defeating: empirically, “soaking the rich” by raising the rate of taxation has a debilitating effect on economic growth and the medium-term nominal tax take usually falls. And all the time, she is working within the Office for Budget Responsibility’s debt constraints (she has indicated its remit will be re-defined under her Chancellorship, that moving of the goal-posts we referred to in a recent column) and the markets’ consideration of how much it will fund and at what cost.

“For the birds”

Crude spending cuts need not be the only solution as we repeat in these columns ad nauseum. It is not just about how much is spent by the government as it is how effectively it is spent. Here the opportunity is significant for far-reaching public sector reform, the Holy Grail of fiscal policy being to get more for less by doing things better and differently. The corollary is true: doing the same thing over and over again and hoping for a better result is the proof of Einstein’s Parable of Quantum Insanity.

There is an argument that Labour might be better equipped than the Tories to drive fundamental reform, notably in health and welfare. It would require significant political bravery. The reaction of the leader of the Unite union, one of Labour’s biggest financial backers, to Reeves’s speech this week reveals the resistance she is likely to encounter. Even without any hint of reform, her plans were immediately debunked; here is what Sharon Graham the union general secretary had to say: “if you stick to phoney fiscal rules, rule out taxing the wealthy and pander to the profiteers, you end up in a straitjacket of your own making. Ripping up building regulations and tinkering in the public sector are not going to deliver serious growth. That’s for the birds”. Ouch.

Mind the Gap

Graham’s reference to “ripping up building regulations” is more than a nod to perhaps the biggest challenge Reeves faces trying to light a fire under the economy: the UK’s chronic productivity gap, which has widened significantly since Covid when nearly 3 million adults who could be economically active have simply absented themselves from the workforce whether through personal choice or under relaxed rules, being signed off sick. In the Budget this month, the OBR was forced to concede that its growth forecasts to the end of the decade are entirely underpinned by economic migration fulfilling the labour gap left by the indigenous workforce. It is that significant net economic (i.e. ‘legal’, as it is defined, now with its own minister) immigration which puts pressure on the housing market and creates demand for new capacity (so much hot air is generated about planning regulations being a significant economic brake that you wonder whether immigration is needed to keep the housebuilding industry in business, or housebuilding is the prerequisite of meeting the need for economic migrants; it is a moot point). But unless the productivity gap is bridged and the UK starts working again to its full capacity, the ability to compete internationally, to attract foreign inward investment, to generate sustainable above-average growth will be significantly impeded. And this is without opening up the can of worms about the political consequences of almost unfettered immigration, or Angela Rayner’s plans for employment law reform giving significantly greater powers to trades unions and adding rafts of complexity and cost to employers.

The Green Deal

Finally, Reeves’s own ambition to go down in history as the “Green Chancellor” who turned the UK into a global “Green Powerhouse” remains undimmed despite having to unravel much of her “Securonomics” programme designed to emulate Joe Biden’s Inflation Reduction Act. For whoever is in power over the next three decades, the legally binding commitment for the UK to meet carbon net-zero put in place in the last days of Teresa May’s premiership with little more than a nod-and-a-wink between her and Parliament requires us to spend/invest what independent experts estimate to be in excess of £2 trillion (almost the size of today’s economy). Time will tell whether it is either achievable or affordable but the commitment is there on the statute book.

It’s on the label: “Securonomics” is explicit about secure foundations; faced with these immense economic and political pressures, in these early days of warming up business, investors, the markets and the electorate that Reeves is a safe pair of hands, she has a great deal of work to do to persuade us that her economic plans are built on rock rather than floating on sand.  

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