Merlin Weekly Macro: Problems mount at 11 Downing Street

This is an important week for the Chancellor, Rachel Reeves. Her problems are daunting and mounting. Having promised a strategic reset of the UK economy last October at her maiden budget (“these are my choices” she kept repeating ad nauseam to demonstrate she was firmly in command, making the point she was wresting order from the chaos of her Tory predecessors), only five months on she finds herself in a considerable jam. 

“Stagflation”: the spectre which haunts the Treasury 

The most significant problem, the complete evaporation of economic growth, is largely of her own making, with a helping hand from Deputy Prime Minister Angela Rayner and their combined assault on employment. It was obvious to everyone except the Labour government that ramping up the taxation on employment through employers’ National Insurance while simultaneously giving workers additional rights and employers extra frictional costs of employing people, would be economically corrosive. And so it has come to pass as companies impose hiring freezes and seek to reduce their wage bills with the inevitable direct consequence of a hit to business confidence.  

She is confronted with the worst of all worlds: “stagflation”. No growth but a rising inflation rate where the Bank of England sees the Consumer Price Index (CPI) climbing to 3.75% in the autumn. From April 1st, the consumer energy price cap will rise by 6.4%, fuelled not by the oil price which has remained largely stable and comparatively weak, but by international wholesale gas prices which are significantly higher than a year ago. Rising ‘green’ levies on energy bills to fund the decarbonisation of the electricity grid are not helping. But of greater concern is that annual wage inflation is averaging 5.9%, almost exactly treble the target headline rate of 2% inflation to which the Bank of England is tasked to manage the economy. Intuitively it should not be so: there is no economic growth; employers are trying to cut wage costs; productivity is chronically and seemingly intractably weak; there is competition for labour in services and construction but then again, 2.7m people who are capable of working have absented themselves from the workforce and are defined as ‘inactive’. It creates a false impression that at the 4.4% official unemployment rate, the UK is close to what economists regard as full employment. The significant public sector wage give-aways last year (‘give-aways’ because there were no strings attached, no requirements to improve productivity or to change working practices) have certainly contributed to overall wage inflation but they cannot explain all of it.  

She seriously thinks that the impediments to growth and investment are all someone else’s fault. Blame Donald Trump for his tariffs; the UK regulators; an intransigent civil service. And yet on top of making it far less attractive to employ people, she has also introduced an ideological war on private capital. Her decision to apply Inheritance Tax to tax the transfer of business assets on death undermines the foundations of the continuity of capital (so too at the personal level, the abolition of the IHT shelter for pension pots). If an entrepreneur and prospective employer knows that his or her new venture will see the fruits of their labour and risk-taking be significantly undermined when they die, potentially threatening the very viability of the business, why bother in the first place? It might be a policy which plays well in the socialist gallery of the redistribution of wealth (which was an explicit Labour ideal in its manifesto) but it is economically illiterate at worst and contradictory at best when it comes to wanting to create wealth and grow the economy, both of which were also manifesto aims. 

Proving Einstein’s Parable of Quantum Insanity 

The government borrowing figures released today show the inexorable upward pressure on the Treasury finances. The fiscal headroom Reeves hoped to have secured from the Budget has all but disappeared. However much she hopes to find cost savings (yet another “war on waste”), the most immediate are small change. The bigger ones, e.g. cutting the health and disability benefits bill by £5 billion by 2030, are long-term and subject to spin. It is wishful thinking that the benefits cut programme announced this week slashes the current annual bill from around £47.5 billion to £42.5 billion; in reality it is a desperate attempt to constrain the bill to £71 billion rather than reaching the £75.7 billion originally projected (and note, those projected figures exclude any provision for index-linking).  

Against her wishes she has been forced to find an extra three-quarters of a percentage point of GDP over the next decade to fund defence recovery (“there is no magic money tree for defence” she maintained all last year, as did Armed Forces Minister Luke Pollard who said “defence spending can only grow when the economy grows”), hence the raid on the overseas aid budget to help defray the liability. 

The prospect of the government balancing its books seems as remote as finding the proverbial pot of gold at the end of the rainbow. It is still locked in the mindset of taxing more (the Office for Budget Responsibility forecasts that the tax burden will continue to rise in this Parliament) and attempting to find crude ways of spending less. The former is corrosive and the latter is reductive. The essential challenge is not simply to do less of the same thing but to do things very differently. Seemingly, no political party either has the bravery or the brains to do that.  

Labour’s natural tendency is to centralise and to impose control. As Wes Streeting begins the task of deconstructing the spaghetti-like confection that is the National Health Service and transforming it to a strategic health screening and illness-prevention service, as yet there is no hint of any suggestion of changing the fundamental principle of “free at the point of consumption” and introducing a funding model based on insurance. A wholly different funding model is going to have to be found for transport as fuel duty dwindles over the next decade; so why not do the same for health?  The abolition of NHS England removing a top layer of management confers greater direct control from Whitehall. Much the same is happening in education as a result of Bridget Phillipson’s new constraints being placed upon academies and the independent schools about curriculum content and even down to the micro-management of their estates where in future every school will be required to secure permission from the Department for a change of use of any building. Such an all-pervading mindset of centralising control (the government has already created nearly 30 quangos since coming to office) feels incompatible with the ambition to achieve growth. That is not to say that growth will not happen; but what is needed is a consistent long-term growth rate of at least 2% to see a restoration of competitive positioning and enduring relative progress. It is not immediately obvious that Labour is any closer to understanding how to achieve it. 

The dead weight of government borrowing costs 

There is one insidious cost which keeps rising, and very sharply: that of servicing our government debt. The nominal debt itself is still increasing thanks to the government’s enduring deficits.  Notwithstanding the three-quarter point cut in Bank of England base rates since last summer, the government’s effective interest rate is rising thanks to the blended composition of the debt structure and the refinancing of sovereign bonds reaching maturity. A 5-Year Gilt issued in early 2020 would have had a fixed coupon (rate of interest) of around 0.3%; maturing today and being refinanced for another five years, its coupon will be 4.6%. The combination of a rising level of borrowings and the changing composition of the blend of outstanding government stock has caused the government’s gross interest bill to more than double since 2019 to around £100 billion in 2024/5. It will rise further. It is a quirk of the numbers that the nominal increase in debt interest happens to be almost exactly the equivalent sum as the annual defence budget. 

No doubt the Office of Budget Responsibility will produce a new long-term forecast after the Spending Review. But what should be concentrating everyone’s’ mind is that on its current median projection, by 2074 the UK will be labouring under the burden of 275% government debt/GDP (100% today) and will be paying away 12% (4% now) of GDP in interest. The tipping point is 2050 beyond which the debt and interest trajectories are that of a runaway train. That’s when we’re bust. No responsible government or Chancellor should knowingly aid and abet that. 

Be brave!  

Ahead of the Spending Review on Wednesday, therefore, a plea to Ms Reeves: come on Rachel, now’s your big chance. As you say, things have changed but this is where a visionary Chancellor can really make a difference. Be brave and do something radically different that economically puts the “Great” back into Britain. Become the Iron Chancellor. If you don’t, you risk being simply yet another failed occupant of No 11 Downing Street who did nothing to stop the UK sliding to penury. Over to you.  

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