Merlin Weekly Macro: Tinkering at the edges of the UK economy

Having previewed the Chancellor’s Spring Statement last week, the summation of Rachel Reeves’s well-trailed readjustments to public spending lived down to our lowest expectations. Tinkering at the edges, we could see no evidence of the prospect for fundamental public sector reform. Of the hoped-for bravery, there was none. We might have known.

‘Austerity’? Don’t believe a word of it

From their different perspectives, all the hollering from the government’s critics about ‘austerity’ (the word that will pass no cabinet member’s lips on pain of death) and from its champions about the ‘war on waste’, is largely tosh. Tory wittering about Reeves not going far enough with cost savings is correct but when it comes to controlling expenditure the Conservatives’ record in office says they have neither fresh ideas nor a leg to stand on.

Page 97 of the Office for Budget Responsibility’s (OBR) post-Statement re-forecast of spending and income plans is instructive: in the fiscal year 2023/4 (i.e. the last fiscal year in which the Tories were still in power), central government total managed expenditure (TME) was £1.230 trillion, or 44.7% of GDP (gross domestic product, a measure of the size of an economy); by 2029/30 the nominal spend was forecast to be £1.510 trillion at the time of the Budget last October, and is now estimated to be £1.519 trillion (43.9% of GDP) in the aftermath of the Spending Review. Annual TME will rise by £289 billion between now and the end of the decade; the cumulative increment over the period of this parliament between what was assumed in October and what is projected now is an extra £56 billion. The complainers are concerned it is not £5 billion higher. That the spending as a percentage of GDP falls by the end of the decade is purely a function of the OBR now projecting higher GDP growth than anticipated of 2% towards the period-end, having in the meantime halved the 2025 outlook to 1%. 1% real GDP growth this year is already a tall order given that year-to-date recorded growth has been elusive. And that was before the corrosive effect of any of Trump’s tariff shenanigans coming into play (for example it would exclude the effect of Trump’s 25% blanket tax slapped on the import of all cars announced with exquisite timing hours after the Chancellor delivered her Statement).

On the other side of the ledger, looking at the government’s tax receipts, they are projected to rise from £1.101 trillion in 2023/4 to £1.445 trillion in 2029/30, a £344 billion increase. A shortfall in corporation tax and VAT income against the October projection is not offset by the increase in employers’ National Insurance receipts (a gap of £3.2 billion). On the other hand, the combination of above average wage rises continuing at 4%+ and the effect of fiscal drag (more people paying a greater nominal sum in taxation as wages rise but allowances and tax bands are frozen) implies that collectively by 2029/30 we will be paying £70 billion more per year in direct income taxes than today, and £6.1 billion more than anticipated only five months ago. Overall, the tax burden (which includes Income Tax, National Insurance, Council Tax, VAT, all capital taxes, Business Rates, and all duties e.g. fuel, tobacco, alcohol, insurance etc) will rise to 37.5% of GDP by the end of the decade against the 35.5% inherited from the Conservatives.

A racing certainty: the forecasts will be wrong

Hawkeyed readers with a calculator will have joined the dots in the context of implied borrowings: by the period end, the deficit is shrinking. There are significant caveats to this, as Rachel Reeves has already encountered in the very short period since she ‘reset’ the economy and bought herself what she thought was fiscal head room: projections, even those of the OBR, are not numbers cast in stone as guaranteed outcomes. They can unravel quickly.

Governments are supposed to control expenditure: however, inefficiencies and project mismanagement often lead to budget overruns; for payments that are index-linked (e.g. pensions or benefits), inaccurate inflation forecasting can see actual outflows diverging from spreadsheet projections (of course that applies both ways and can lead to over- and under-expenditure). Regarding receipts, governments set the rate of taxation but they do not control the nominal tax take: they do not set private sector wages, nor do they manage corporate profits, for example. Finally, when looking at borrowings as a percentage of GDP, while central government can hope to influence economic growth, it most certainly does not control it (and this government with its contradictory policies has no idea how effective growth is to be achieved).

So when considering the anticipated deficit and the extent to which it is ostensibly narrowing (i.e. improving), or when looking at the national gearing ratio (meaning the ratio debt to GDP) there are many moving parts over which the government is powerless that may derail the outcome and surprise in the opposite direction.

The following chart taken from the OBR’s latest “Economic and Fiscal Outlook” published this week clearly demonstrates the propensity for long-range economic forecasting to be wrong. It shows forecasts for UK public sector net debt made at the dates specified. In previous years the actual level of public sector net debt has exceeded those forecast levels.

Successive forecasts for public sector net debt, excluding Bank of England

The March 2020 forecast was redundant, literally within days of publication: Rishi Sunak’s anticipation of a £55 billion deficit ballooned almost tenfold thanks to the pandemic and the fiscal measures taken to keep the economy afloat during lockdown; that was extraordinary. But half a decade later thanks largely to rapidly rising benefits, health and debt interest costs, the seemingly relentless upward pressure on borrowings has all the hallmarks of becoming an enduring inevitability. As now, faced with having to find an extra three-quarters of a percentage point of GDP to fund defence which had not been pre-planned, the government is confronted with peremptory decisions for which it is under-prepared politically, fiscally and financially. However much the case for a radically different approach to public sector economics is screaming out, few if any at Westminster are listening.

The OBR has so far not produced a revised long-term outlook but if it were to do a projection for 2074 of 275% debt/GDP and 12% of GDP being paid away in interest costs, that the absolute numbers would be wrong but all things being equal the direction of travel is likely to be depressingly correct.

The Politics of Defence

It is obvious that defence spending has become an urgent topic. It is no great exaggeration to say that in the UK Spending Review, alongside raiding the Overseas Aid account, the benefits budget is funding bombs and bullets. That it should be so is thanks to the post-Cold War ‘Peace Dividend’ and 30 years of underfunding defence and a threat that has not only rapidly multiplied but crystallised. An appropriate simile: it has been like a long but very visible slow-burning fuze which has suddenly gone from flash to bang. As the government commits to 2.5% of GDP to be spent on defence by 2027 up from 2.3% in 2024, with the hope of achieving 3% in the next parliament (“when economic conditions allow”), it is not surprising that shares in defence contractors have risen sharply (Merlin Investment Director Alastair Irvine’s ‘Call to Arms’ national security blueprint published on the Jupiter website on 21 February explains why 2.5% does not even begin to touch the sides). But in the EU even with Donald Trump and JD Vance on its back, not to mention the Russians, Brussels still manages to politicise a security crisis. Community in mutual protection and defence in Europe? Forget it.

When it comes to extra defence spending and the concept of shared burden for mutual protection, the grass-roots mood is truculent among the European ‘GDP Trillionaire Club’ required to do the heavy lifting. However much President Macron of France is in his element posturing with Keir Starmer as one of the co-heads of the ‘Coalition of the Willing’ for Ukraine (for which there are not many coalescing and even fewer who are willing), the polarised French parliament with no political centre is in no mood to cut Macron any slack. Le Pen on the far right is sympathetic to the Kremlin and no fan of Ukraine; on the far left, extra money for defence is ideologically anathema. Similarly, Spain and Italy are either politically or financially constrained. Germany might have passed the change to the constitution to amend the debt brake law giving fiscal exemption for an extra 1% of GDP for defence spending and more again for infrastructure, but new Chancellor Merz has expended significant political capital with the public in doing so (and as we have pointed out before, markets have reacted by hiking the cost of German borrowings as the physical risk of being run over by the Russians is replaced by the financial risk of ensuring the Russians are kept out). On the other hand, on the front line and also wanting to show Trump that they are good allies and they need his unconditional help in the event of a Russian attack, Poland is already spending over 4% of GDP and Latvia has recently announced that it will henceforth spend 5% on defence.

Since Trump’s very public remonstration with what he sees as the Defence-spending delinquents in his first term, and spurred on by Putin’s invasion in 2022, led by Macron and EU Commission President Ursula von der Leyen Brussels has created a partial ‘nationalisation’ of defence procurement. Laid out in March 2024, as it appears verbatim on the European Commission website:

 “The Strategy sets out several new actions to achieve this:

• encouraging EU countries to invest more, better, together and European. This will be promoted thanks to new programmes to buy and work more easily together at the European level.
• making European defence industry stronger, more responsive and more innovative. Steps will also be taken to support research, boost investment and work on issues along supply chains. As part of this, an Office for Defence Innovation will open in Kyiv.
• funding to ready the defence industry, through a new European Defence Industry Programme worth €1.5 billion and discussing defence needs for the next long-term EU budget.
• teaming up with partners across the globe - Ukraine will for instance be able to take part in EU defence industry programmes.

The Strategy also sets out a number of targets. By 2030, EU countries should:

• buy at least 40% of the defence equipment by working together
• spend at least half of their defence procurement budget on products made in Europe
• trade at least 35% of defence goods between EU countries instead of with other countries

This will help make the EU safer and more resilient. It will not only benefit all of us in the EU, but also key allies including NATO and Ukraine.”

Frigates and Fish

All good in theory. But this is the EU we are talking about. Not only designed to enhance mutual physical protection, but it is also deliberately protectionist industrially while centralising control in Brussels. The small print lays down the principles of a central authority determining to whom what are currently national defence contractors may or may not sell weapons outside the Union; it also has potential repercussions for non-EU defence contractors (such as BAe Systems) who are in joint ventures with EU partners on specific programmes e.g. Eurofighter (the RAF’s Typhoon). It is ironic that Kyiv is specially mentioned as a beneficiary: as noted in these columns before, the inception of the supply chain programme reform directly caused the significant disruption in the delivery of artillery shells promised by the EU, such that last year less than half the quantity promised was in fact delivered (as we have observed in this context before, with the EU it is a case of policy and process first, the obligations of safety and security second, even in an emergency). UK defence contractors are among the biggest financial beneficiaries of Polish rearmament; under the new rules the Poles would have been forced to shop in the EU first, regardless of the efficacy of alternatives sourced outside the EU.

The latest simmering tension is over the EU’s decision to create a €150 billion defence fund from the central Brussels budget from which member nations can draw. Only EU members can benefit; that is pragmatic in that only those who contribute to the EU budget (even if net beneficiaries) should be allowed access. The UK is not a member, its final post-Brexit payments have been made, therefore it cannot draw on the fund. But the EU wants the UK inside the defence tent: militarily it is the most effective force in Europe (despite the paltry numbers it can field) and it has nuclear weapons, the only European country aside from France to do so. As it stands, not only can the UK not access the €150 billion central fund, the EU insistence on a formal defence pact with third parties to be a ‘valued partner’ in the broader procurement programme also closes out the UK as a prospective customer: post-Brexit we have no such treaty. The conditions being tabled for access are the usual suspects which were so toxic in the Brexit negotiations: free movement of people/immigration, and at the insistence of the French and the Spanish, the surrender of the UK’s sovereign fishing rights.

‘All is fair in love and war’. For Europe, even what should be the unconditional unifying need to face down Putin becomes an irresistible game of internecine political chess for Brussels and the EU, and a negotiating starting point of ‘heads I win, tails you lose’ with its partners. Plus ça change.

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