April 2025 – thinking liberal

Liberation Day 2: American turmoil

Trying to write a considered commentary on events in America is a hazardous business. Things will change even as you write. In the middle of preparing this article President Donald Trump executed a screeching handbrake turn on his tariff policy, having paused the higher tariffs for 90 days. This leaves it as a universal 10% tariff, with massive mutual tariffs remaining with China. Stock and bond prices bounced back sharply with a huge sigh of relief. The political pressure on Mr Trump evaporated. But the dust hasn’t settled, and on any other day the remaining tariffs would have constituted a major escalation; bond market troubles may well be more deeply sourced; questions remain over the direction of tariffs in future. Disaster still beckons.

The economist Paul Krugman, whose Substack I recommend, warns against the “sanewashing” of Mr Trump’s policies – the projection of a rational strategy when none is there. This will lead to disappointment. There is not a coherent strategy behind his tariff policy – it has conflicting goals, for a start – but it flows from strongly-held beliefs, and some of his advisers have a more coherent take on it. The most important of these is Peter Navarro, who wrote an article for the Financial Times recently; I would recommend reading it if you want an insight into the administration’s outlook.

Mr Navarro presents a long list of grievances: of unfair trading practices from America’s trading partners, which are leading to a hollowing out of the United States, and a system that is tilted against it. That has led to a substantial overall deficit, and huge individual deficits with many countries. Europe bans America’s chlorinated chicken; China manipulates its currency; Vietnam acts as a conduit for Chines goods; and so on. The “reciprocal tariffs” – now in suspended animation – are a quantification of these trade barriers; he does not explain that they are simply half the ratio of trade deficits to imports, subject to a minimum of 10%. This picks up on two ideas explained in my previous post. First is the “victim narrative” of trade deficits: domestic production has been suppressed by unfair competition, meaning that it cannot fulfil domestic demand, which is in turn sustained by capital transfers from abroad. These transfers are being used to buy up American assets, ceding control to overseas interests. The second idea he picks up on is that fair trade implies that there should be no deficit at at all between countries; any imbalance is therefore evidence of trade distortion – and so as the proposed tariff is proportional to the deficit – the fewer the distortions the lower the tariff. Lost in that is the fact that 10% is still a high tariff by current international standards, and that it applies even to countries with whom America is in surplus. Mr Navarro shows that there is enough evidence for his narrative out there if you really want to believe it. I don’t know enough about the man to understand why this is – just that he has held these views for a long time. Other narratives and supporting evidence is available. After all, if America is being ripped off, why does it have the most successful economy in the world?

Mr Trump’s thinking is broadly consistent with this, though without its intellectual gymnastics. His view is more akin the idea of Mercantilism. This idea was developed by the 17th-Century French statesman Jean-Baptiste Colbert, who was first minister to Louis XIV. Colbert was a brilliant administrator, and his ideas set the tone for European statecraft for a century. He suggested that trade was about maximising exports and minimising imports so that the country would accumulate wealth, which at the time could be equated to “treasure”, the banking system being pretty crude. This was the set of ideas that were unpicked by Adam Smith and David Riccardo more than a century later. The French economy at the time consisted of a state dominated by a substantial war machine (there was barely a year when Louis was not at war) financed by excise duties and taxes on the poor. An export surplus would have implied suppressed consumption by the aristocracy (the poor had nothing left to give), which I suppose was not really a hardship. So far as Mr Trump is concerned, exports imply money coming in; imports represent money going out – so surpluses are power, while deficits mean you are being ripped off. His business philosophy is very much that if you not ripping somebody else off, you are being ripped off yourself; the idea of mutual benefit does not compute.

But Mr Trump’s love of tariffs goes further than countering perceived trade distortions. He also wants an extra source of tax revenue that he can tell his supporters that foreigners are paying rather than them. In his wilder moments he dreams of this replacing income tax. After all, income tax was brought in at first, both in America and in Britain, to compensate for the loss of tariff revenue from free trade. Of course to generate substantial revenue then the US must continue to import lots of goods. His supporters suggest this might come about through the strengthening of the US dollar, as happened to some extent in his first term, to offset the cost of the tariff. The tension between this and reducing deficits and protecting US industry is obvious.

Another aspect of tariffs for Mr Trump is that he hopes it will turn the clock back to a time when America had a lot of manufacturing jobs. Many Americans have fond memories of when many working class people had reasonably well-paid and stable (and unionised…) jobs in manufacturing. According to the MAGA mythology these were the jobs destroyed by unfair foreign competition, so rebalancing means that they jobs can come back.

And yet another reason to like tariffs is that it allows Mr Trump to throw his weight around on the global stage and make deals. He gets high on what he sees as grovelling by foreign governments to reduce tariffs by dismantling trade barriers; he makes sure that his fellow Americans see their humiliation. Many of Mr Trump’s cheerleaders from the business world thought that this was the main point of his tariff talk, and that they were just a negotiating tactic. Just like Russia’s military buildup on the Ukrainian border in early 2022 was supposed to be something called “power diplomacy”. But the Liberation Day system is so comprehensive that it appears negotiation will be just around the edges. Anyway you can’t do 70 highly personalised bilateral deals at once. It is now unclear what future negotiations will be about. Will some countries be allowed to escape the 10% lower limit? Is it about modifying the suspended “reciprocal” scheme? Or will the focus be on the special regimes for cars and steel – as the British government appears to believe. Nobody, including Mr Trump, knows.

But problems are coming in multitudes. The first is that, whatever Mr Trumps says, tariffs are a tax on American consumers. Americans cannot avoid buying imported goods (often as components of more complicated things like cars), and prices will rise across a wide range of goods. America is less dependant on trade than many economies, but even so they will have a significant impact. There will be a temporary bump to inflation. The Federal Reserve might be induced to raise interest rates. I think that risk is overdone; it is a temporary adjustment, and unless a wage-price spiral is threatened, there is no longer term threat. Weakness in the wider economy reduces that risk. The main problem is political: Mr Trump suggested that he would cut prices rather than raise them. The MAGA faithful will accept that this is a short-term adjustment and that better times are around the corner; many other Trump voters will feel let down, or even betrayed.

Next the economy will weaken, perhaps to the point of recession. The problem here is less the extremity of this particular policy (which has been softened after all), but the perception of instability across the whole of American public policy, which has become dependent on one mercurial individual with little grasp on reality. Mr Trump talks of vast amounts of inward investment, as firms promise factories in America to avoid the tariffs. But long term investments require a stable economic outlook; companies will delay doing much until things settle down – which could take some time. Exports are likely to suffer too, from retaliatory action by foreign governments (and especially China) and from a loss of confidence in America generally. Foreign visitors, especially students, are alarmed by the arbitrary application of policy that can see visas revoked on a whim, and detention at the border. This might help reduce the current account deficit – but through making Americans poorer.

The questions really start to arise when trying to picture the American economy the Trump administration is trying to create. He wants to shield US businesses from competition. That means that inefficient businesses are given a lifeline, and more efficient businesses don’t need to try as hard. That is not a recipe for economic dynamism – and thus has been the experience of most highly protected economies in history. A partial exception has been Asian economies that have used protectionism as part of an industrial strategy to allow the build-up of new industries. There is no such strategy in America. To be fair, America is a naturally competitive economy, and large enough not to need foreign trade as much as others to keep it so. But still, high tariffs will make America less efficient and wealthy, not more.

And it is hard to see those old industrial jobs returning. Technology, more than foreign trade, was responsible for their demise, and there has been a Baumol shift towards services, as Americans see to bank productivity gains in manufacturing by consuming more services. A more rational expectation is that America becomes a powerhouse of modern manufacturing business, in highly automated businesses, which export much of their output. But that entails a level of investment that will not happen in the current chaotic policy environment – and tariff barriers are not a particularly good way to achieve it. President Joe Biden’s use of subsidies was a more realistic idea.

But am I overdoing it? Will it be a matter of disappointment rather than disaster? Well, maybe. But that will entail the Trump regime rowing back on its revolutionary mission. Anything is possible in Trump World.

First published on Substack 12 April 2025

Liberation Day 1: the economics of trade

It is hard to overstate the significance of President Donald Trump’s Liberation Day US tariff plan, announced last week. It is a rewriting of the world order – and America’s place in it. It’s going to take more than one article from me to explore its significance. This time I want to look at the general context – as this is essential to understanding how things might develop from here – and it is very widely misunderstood by even expert commentators. The president’s action looks like one of the most colossal acts of self-harm in history – but the impact on the rest of the world may not be as bad as many suggest.

Any discussion of the economics of trade must start with the idea of comparative advantage – first articulated by David Riccardo 200 years ago. It is one of the most powerful economic ideas out there, and it is also one of the most neglected. I don’t want to go back to Economics 101 here. Suffice to say that the theory shows that trade is driven by opportunity costs and not productivity. There is a limit to how much each country can produce – and if each one specialises where it is relatively the most efficient (but not necessarily in absolute terms) then production across the world is maximised and everybody should benefit. Differences in actual productivity are taken care of by exchange rate differentials. It is why equilibrium exchange rates do not conform to purchasing power parity. “Comparative Advantage” may sound rather like “Competitive Advantage”, and we may often make an analogy between a country and a firm (“UK plc”) – but they are very different things. In economics firms compete but countries do not – they optimise. Tariffs, meanwhile, distort pricing signals and lead countries to sub-optimise.

This theory does a wonderful job of explaining the world we see today – why there is so much trade, and why and how exchange rates differ from purchasing power parity (i.e. currencies buy different amounts of goods and services in different countries). What it doesn’t do is help with the sort of fine-grained predictions needed for economic models. That requires a very detailed understanding of economies and what the opportunity costs are – way beyond the capabilities of current economic data and analysis. Attempts to model it at an intermediate level, by looking at broad factors of production (land, human capital, etc.), have failed. In modern economics, if you can’t put it into a model, it’s no use at all. So while most economists have a general idea about comparative advantage, it’s a distant memory from their undergraduate days. They haven’t thought about it very much. Politicians and political commentators pick up on the general idea but garble it – falling into a fallacy of composition (assuming that the production side of an economy is analogous to a firm) and muddling competitive and comparative advantage.

Two insights get lost in all this. The first is that the theory has nothing to say about trade deficits and surpluses. In the standard exposition, exchange rates should adjust so there are no deficits or surpluses – though whether this applies country to country, or to countries across all their trading relationships is an interesting question that I’m unable to answer. I will come back to that. The second is that the benefits of trade are driven by difference – and that the more similar economies become the fewer gains from trade there will be. Let’s take a closer look at that in the context of the US and China.

In 1990, when trade between the two countries started to open up, the US was one of the world’s most advanced economies and China one of the least developed, after the failure of Maoist Communism. Most of China’s workforce was tied up in massively unproductive agriculture. Only a tiny proportion of America’s was in its hyperproductive productive agriculture. America had a massive comparative advantage in agriculture; China therefore had a comparative advantage in pretty much everything else that was tradable, apart from technologically advanced goods that were beyond its capability. To put this another way, China’s hideously unproductive agriculture sector meant that Chinese wages were tiny compared to America’s, which meant that even very inefficient manufacturing businesses were highly competitive. And so they had the basis of massively beneficial gains from trade. America exported agricultural products and advanced goods, while importing cheap manufactured goods. Both countries benefited from cheaper inputs.

So far, so good. But the situation was dynamic. Rural workers in China responded to the demand for extra manufacturing jobs; rural productivity improved. Chinese manufacturing invested; infrastructure was improved; productivity and wages rose. America and China converged. It follows that the gains from trade diminished. This has mostly been at America’s expense. Chinese goods became more expensive relative to domestically produced ones. Meanwhile, because productivity was advancing rapidly, in China the lost gains from trade were compensated for by gains from productivity. This has been replicated on a global scale as the dynamic between developed and less-developed countries. There were massive gains from trade in the early days, and a convergence between the two sides that has seen the biggest ever eradication of extreme poverty. But the gains from trade are now much less. This is one of the reasons that living standards in the developed world have struggled since the mid-2000s; access to ultra-cheap goods from the less developed world has drastically diminished. This development is almost unacknowledged by economists; the late great Paul Samuelson has been to the only one that I have seen to point this dynamic out – largely before it happened. Instead people are bewailing the loss of a system of global trade that delivered so much benefit in the past.

The world has progressed in another way. Manufacturing productivity has advanced steadily, mainly through automation, but also through better process management. This has tilted the balance of developed economies towards services that are largely untradable. This means that the impact of trade on developed economies is steadily diminishing.

This doesn’t mean that gains from trade have disappeared. Surely it still makes sense for Apple to make its iPhones in intermediate economies? But it does mean that strategic considerations are weighing more heavily than commercial ones. In particular both America and China are worrying about what would happen if war broke out between them – an increasing risk given China’s ambitions to absorb Taiwan. It also doesn’t mean that the reordering of manufacturing supply lines that the Trump administration seeks won’t be painful and disruptive for both America and its trading partners – especially those in East Asia. But it does mean that ultimately it will almost certainly be worse for America than anywhere else. I want to talk about the impact on America in more detail in my next post.

But what about trade deficits and surpluses? A current account deficit represents an excess of demand (consumption plus investment) over supply; a trade deficit has a slightly narrower definition – it applies to goods – but it is much the same thing. If demand can’t be met by local supply, you need to imports to make up. This, however, tells you nothing about what caused it. The victim narrative suggests that the surplus of demand arises because domestic supply is being driven out of business by competition from abroad. The economy then runs up debt (or sells its assets to foreigners) in order to maintain demand, which has to be supported by imports, and it all ends in ruin. An alternative, boomtime narrative is that consumers are on a demand binge which domestic supply cannot meet. Foreigners are happy to finance this because this booming economy provides opportunities to make returns. Trump supporters are scarred by the sight of business closures with the excuse of foreign completion being given, or outsourcing to cheaper suppliers abroad, and point to victim narrative. Trump critics point to low US unemployment and a healthy economy, and say that there is no obvious case that the supply side is being suppressed – and so lean to the boomtime narrative.

But there is a further dynamic. Some countries, including Germany and China, enjoy trade and current account surpluses as a matter of policy. They achieve this by, one way or another, suppressing demand so that the supply side can generate a surplus to export. This might be by underpaying their workers and letting businesses accumulate profits; it can be through governments over-taxing and leaving an unspent government surplus; or it can be through a conservative public forever saving for a rainy day. Why do governments let this happen? A surplus means that the country does not require foreign finance, and that generally makes the national finances easier to manage; for dictatorships, like China, that can be especially important. If some countries run a surplus, then others must run a counterpart deficit. This pattern can help fuel the victim narrative of deficits. The alternative view is that surplus countries are selling themselves short – they could charge more for their exports and/or allow their citizens to consume more – and that deficit countries are beneficiaries of this generosity – and should be sending the surplus countries thank you notes. Which narrative (and others are available) better fits the facts depends on the circumstances. One the one hand you might have a colony being exploited by its ruling power; on the other you could have an industrial powerhouse using foreign capital to build up its infrastructure and industrial base. You need to get beyond the raw statistics to work out what is going on.

There is an argument that all trade should be in balance, and persistent surpluses and deficits show distortions from “fair” trade. This comes up quite a bit for people trying to “sanewash” Mr Trump’s actions. He himself seems to have a much cruder understanding: a surplus means you are getting one over on the other side and building up wealth; a deficit means you are being ripped off and seeing your wealth disappear into foreign pockets. The idea that surpluses and deficits may simply be a reflection of supply and demand being out of kilter runs counter to this.

What role do exchange rates play in all this? Exchange rates should adjust to an equilibrium that allows trade and capital flows between countries to balance – letting the market decide. Countries can try to lean on the market by buying or selling reserves – but this only really works to manage short-term blips where governments think the markets are temporarily distorted. Monetary policy, fiscal policy and capital controls all affect the exchange rate, and can be used to fix exchange rates – but ultimately because these policies work because they affect supply and demand, and the capital flows required to finance them. You can get too hung up on asking what a “fair” exchange rate is.

What is the impact of the Trump tariffs on the world economy? In the short term there will be a lot of disruption, and we have only seen the start of it. There are two pressure points that will need close attention. The first is less developed economies that have been slammed with high tariffs: notably Vietnam, Thailand and Bangladesh. These do not have the resilience (or negotiating power) of bigger economies, such as China, Japan or South Korea. They may be able to divert to other markets, but long term damage looks likely. The second is in the financial system; this has been delivered a series of shocks by the Trump administration, of which Liberation Day is merely the biggest. A lot of bets made by intermediaries have gone sour and these could have ripple effects that start to endanger bigger institutions – this is what happened to Liz Truss’s government in the UK in 2023, causing its demise. A danger sign is that the price of safe haven assets, such as US Treasuries, has been sinking alongside riskier ones. An added risk is if China starts to dump its some of its substantial holdings of US Treasuries – which it might need to do to counter the disruption of trade. A new financial crisis might develop.

But this crisis is not the end of globalisation: it simply marks exit, or intended exit, of the US as a global trading power. The rest of the world can carry on trading more or less freely with itself – and that seems to be what they want to do. And in some respects America will continue as a global commercial power: Google, Meta, Apple, Microsoft and even Amazon will be disrupted but there is no fundamental threat to their business models. The globalisation of information will go on. The big question is who, if anybody, will take up America’s leadership role? China could curb its own tendency to bully; the European Union could have its moment.

In due course, however, I expect the Trump tariff regime will collapse, and America will come back into the world system as a diminished player. But that’s another story.

First published on Substack on 9 April 2025

Meanwhile, how is the Ukraine peace process going?

Donald Trump’s Liberation Day tariffs shocked even me. I want to respond to it in two ways – first to examine the economics, since I think that the understanding of comparative advantage, the driver of global trade, is weak amongst most commentators; second, the politics of it, and whether the backlash could lead to an early termination of the Trump presidency. But I think both commentaries would benefit from a little more time passing to clarify things. Before that, I want to look at the Ukraine peace process started by Mr Trump’s administration – about which I have commented here previously.

In those comments I suggested that the process would encompass three things: a ceasefire on something close to current front lines; ending sanctions on Russia; and ending US aid to Ukraine. Only a token effort would be made to tackling a longer-term peace treaty. The strategy was first to pressure Ukraine into going along with this broad strategy and then to tackle Russia. The pressuring of Ukraine has gone more-or-less to plan. The second step has got absolutely nowhere.

There was always a puzzle about this process. Why wasn’t the Trump regime placing any pressure on Russia? Instead Mr Trump and his allies repeatedly parroted Russian talking points about who started the war (Ukraine/NATO); the impact of US aid (overwhelming); the legitimacy of the Zelensky government (elections overdue); how the war was going (Russia dominant); and who was the main obstacle to peace (Volodymyr Zelensky) . Russia, meanwhile, made plain their objection to the ceasefire idea unless the settlement “dealt with the root causes” of the conflict. This is code for an effective capitulation of Ukraine. Those experienced in negotiating wondered by Mr Trump was being so soft on Russia when it was so clear that a lot of pressure was going to be needed on them in due course. Instead, Mr Trump suggested that Russia would be easier to handle than Ukraine, and that they would be compliant for reasons that only he understood.

Just what was going on? One well-rehearsed conspiracy theory is that Russia has private information on Mr Trump and that they were blackmailing him. I find this hard to accept: surely there really isn’t anything out there that could harm him? Corruption; illicit sex – you name it, Trump can shrug that kind of thing off. There is an ideological overlap between hardline MAGA Americans and Vladimir Putin’s stated ideology – the stuff about white-supremacy, “Christian” civilisation and so on – but I’m not sure this has much sway on Mr Trump himself – he’s a narcissist not an ideologue. I’m left with the conclusion that it is sheer stupidity. I would call it naivity except that Mr Trump has four years experience of the highest office. The Putin regime has sugar-coated its hard line with flattery, talk of its desire for peace and the promise of exciting business deals; Mr Trump doesn’t seem to have got beyond the sugar coating to the bitter kernel what Russia is actually saying. You would have thought that a New York property magnate would have an ear for bullshit – but apparently not.

Still, this is a bit of a gamble for the Russians. They are hoping that the Trump regime will lose patience, blame the lack of progress on Ukraine, and suspend aid and sanctions without a ceasefire. But I think Mr Trump is expecting serious engagement with the ceasefire idea, and will eventually notice that he’s not getting it. The Russians might then end up with nothing. There are some early signs of frustration from Mr Trump. Interestingly, he was especially annoyed by the Russian suggestion that the Ukrainian government should make way for a UN-led interim regime while elections were held. This seems to break one of the principles of Mr Trump’s negotiating approach – after investing so much into bullying Mr Zelensky, removing him would destroy that investment. And yet it’s all of a piece with those Russian talking points.

But I can’t be too optimistic. The Trump regime has an America-first attitude to Europe, in stark contrast to its attitude to the Middle East. There are benefits to the US, as they see it, from ending aid to Ukraine and the sanctions – and so they may very well be tempted to do this without a ceasefire. But the plaudits as a peacemaker that Mr Trump seeks would disappear. Mr Zelensky realises all this and is now playing his weak hand well. He has to give way to American bullying in order not to be seen as the problem party; and this he is doing without being too craven.

Meanwhile the war itself has slowed down. Russia made a strong bid to recapture the territory in the Kursk region it lost to a surprise Ukrainian offensive. They have pretty much succeeded – but casualties were high and progress elsewhere largely stalled. They are doubtless regrouping – but then so are the Ukrainians. A decisive military breakthrough seems a long way off. Two questions lurk. The first is how close is the Russian war effort close to failing from its losses? Some western commentary suggests that it is much closer than most seem to think. Still, the resilience of despotic regimes under pressure can be surprising. The second is how well could Ukraine hang on without US support? It would clearly struggle – but would not fold as quickly as Russia is suggesting, and the Trump regime seems to believe. But both Ukraine and the European powers are desperate not to put this to the test.

What of the European powers? These are being treated with contempt by America and Russia alike. But in a long game their influence is growing. They are putting a remarkable amount of effort into developing the idea of an armed+ presence in Ukraine to secure any ceasefire. This seems odd, as it is categorically unacceptable to the Russians, and the Americans seem uninterested; militarily it doesn’t make much sense either. It seems to be a way of reminding both that Europe has some weight to pull in this affair.

The biggest question of all is whether Mr Putin will break free of the Russian stated position, and agree to a ceasefire without major concessions, in exchange for lifted sanctions (including those from Europe) and a suspension of US aid. It is possible, even if it doesn’t look very likely from where I’m sitting.

First published on Substack

The UK government is hostage to financial markets

This is not (entirely) Rachel Reeves’s fault

As I’ve written before, I don’t warm to Britain’s Chancellor of the Exchequer, Rachel Reeves. This is mainly because of her poor communication skills – she is certainly more on top of her brief, and responsible, than her two immediate predecessors, Jeremy Hunt and Kwasi Kwateng. It seems that the British public shares my prejudice. She is popularly spoken of as a liability. But I think this reflects much wider problems within this government.

Government finance policy needs to achieve four things. It needs to ensure that the government has the resources it needs to deliver on public services and social insurance policy; it must ensure that there are appropriate incentives in the tax and benefits system for the economy to work effectively; it needs to balance supply and demand in the economy at large to ensure that there is full employment and low inflation; and it needs to ensure that the financial markets are kept happy. The problem for the government is that it is the fourth requirement that is dominating the other three.

What do I mean by “keeping the financial markets happy”. It is hard to be precise, but the immediate measure is cost of government debt – what the government must pay to borrow money over the maturities it needs to finance itself. This is more complicated than it appears at first, because it can also affects requirement three – balancing supply and demand. As Britain operates its own currency, which is not pegged to any other, it has the option of financing itself by creating money. This has been done recently through the policy known as “Quantitative Easing”: letting the Bank of England buy longer term government debt. The danger is that this creates extra demand in the economy and causes inflation.

The government’s predicament is defined by three things: elevated inflation, high levels of outstanding debt, and internationally elevated levels of interest required to finance that debt. Inflation is not high, but at the top end of an acceptable range. If it rises then political disaster beckons – firstly because people feel that their living standards are being eroded, and secondly because the cost of home mortgages arises, causing widespread financial stress. The government therefore feels it can’t take liberties with large budget deficits or monetary financing. Debt, meanwhile, is nearly 100% of GDP, a historically high level for peacetime – courtesy the financial crisis of 2007-09, and the covid crisis of 2020-21. A large amount of debt means that interest payable becomes a bigger issue. And the cost of government borrowing is at historically high levels compared to the USA and Germany (both of whom are themselves under some stress) – though not especially high in absolute terms by 20th century standards.

Listening to commentators, you would think that interest costs had the same economic implications as real spending, like running the NHS – just as interest costs are very real to ordinary households. This isn’t really true – it isn’t about mobilising real economic resources, it’s about shuffling wealth around the financial system. It does not in fact have much direct impact on the first three government objectives, but it is critical to the fourth, and so indirectly impacts them. It is possible for nations to get into debt spirals, like households do – but actually pretty rare. The outcome is usually a grim austerity-based international re-financing, with a loos of sovereignty, or else hyperinflation, which usually leads the same way. It’s very rare in developed economies. The Eurozone crisis of 2010, affecting Greece, Spain, Portugal, Ireland and Cyprus has a lot to do with the fact they were part of a common currency area. The interwar catastrophes in Central Europe can be linked to war reparations and naive macroeconomic management. The question is whether this rarity is because finance ministries are so afraid of it that they are more cautious than they need to be – or because the management tools available to modern developed economies are powerful enough to fend off the risk, provided they control their own currency.

In Britain’s case there is no doubt that the government is scared stiff of financial chaos when managing its debt, and is very risk-averse. The financial wobble that brought down the government of Liz Truss in 2023 is seen as a cautionary tale. The reasons for this financial crisis are pretty technical, and arguably just bad luck, but it has made people more cautious than ever. And it certainly did for any suggestion that governments could ignore financial markets. But nobody knows exactly what will cause a breakdown – except that the processes are non-linear. Trouble can happen with little warning.

So how do governments keep markets happy when, as seems to be the case for Britain now, warning lights are flashing? It’s a matter of confidence and trust. The benchmark bond maturity is 10 years, and the ability to issue bonds cheaply for greater maturities makes the overall management process easier – an art that the Bank of England is very good at. So investors need confidence that the currency will hold its value for that long, with regard to domestic prices and, to some extent, with other currencies. I think investors are looking for two things, on top of a strong underlying economy: consistency and restraint. Consistency means that the broad contours of the country’s financial management will remain constant (or perhaps drift in a conservative direction) over the long term. Restraint means that there are checks and balances within the system to ensure that levels of debt do not explode unsustainably.

With this in mind the Coalition Chancellor George Osborne set up the Office for Budget Responsibility (OBR) in 2010 (a moment of high financial stress), and this system has been maintained ever since. The OBR is independent of government and reports on government financial plans twice a year, coinciding with fiscal events, one of which is the annual Budget. It prepares its own economic forecasts and shows how much the government’s published plans will affect the economy. This is the basis on which the government can show that it is adhering to its fiscal rules, without fiddling the forecasts, and governments were prone to doing before 2010. Fiscal rules set limits for the size of budget deficits and levels of debt. This system delivers consistency and restraint for as long as governments stick to it. Tinker with it, and markets become much harder to manage. Ms Truss tried to play fast and loose by letting her Chancellor, Kwasi Kwarteng, deliver a major fiscal event without and OBR report.

But this approach comes at a huge cost. The first issue is that the OBR’s forecasting methods are conservative, though not inconsistent with mainstream economics. That means that radical ideas for reform will be treated with scepticism – the up-front costs are fully loaded but the subsequent benefits treated very conservatively. This is a feature, not a bug. Evaluating reform schemes to distinguish between the half-baked ideas from lobbyists and wonks, and really promising ideas is beyond the competence of such an outfit – and anyway often requires a degree of political judgement. Most ideas that come through the political system are in the former group. Even where the OBR accepts that there will be benefits, it is often over-optimistic. Past reforms to benefits in Britain have not yielded the expected savings for example. The markets want conservative projections, not political manifestos. Alas most promising efforts at radical reform entail substantial costs up-front costs, so adherence to fiscal rules can be severely limiting.

There is another problem. The OBR figures give a false sense of precision. Even estimates of current economic data, such as GDP, inflation and, especially, productivity, are uncertain – never mind future projections. We may live in an Information Age, but reliable data on the economy as a whole is unattainable. I have seen earnest discussions about trends in productivity – and yet the estimates used are bases an uncertain data and heroic assumptions. The only hard data is that on tax receipts, government spending and the level of national debt.

And so the government is forced to take OBR forecasts as holy writ, and tailor its policies to producing forecast outcomes rather than real ones. And Ms Reeves has given us an unedifying display of managing minuscule “headroom” calculated by the OBR. Reforms to the benefit system, where legitimate questions can be asked about its effectiveness, end up looking more like brutal cuts than intelligent redesign. But if Ms Reeves doesn’t play this game she risks trouble in the financial markets.

The biggest problem for the government is that the previous government, and its Chancellor Jeremy Hunt, ruthlessly gamed the system to secure temporary advantage, in the hope that this would turn the political tide in time for the election. The “headroom” was cut to minimal levels; unrealistic assumptions about future cuts to public spending were pencilled in for the next parliament. This was used as the basis to cuts to employee National Insurance that were plainly a very bad idea. This was obvious enough at the time, but Labour failed to call the antics out. That left them supporting unrealistic expectations that they are now paying for. By being politically risk-averse they ended up by taking big financial risks.

What the government is clearly hoping for is a change in the economic data – especially GDP and tax receipts – that will start to give it more margin with which to enact policy. The consensus is very pessimistic (a view that I share for a number of reasons), but good news might emerge from something as insubstantial as a change in public mood – or a reinterpretation of the economic data. Clearly Labour hoped that the formation of a new adult-minded government would be enough to lift the mood. That failed to happen as international news, and especially the antics of President Donald Trump, only made things worse.

One way to give the government extra headroom would be increase taxes. You can make a good intellectual case for doing this on mainstream taxes (income tax in particular), but the government feels that this would be political suicide. They may well be right. The left wants to find ways to tax the wealthy – but this is much easier to do in theory than in practice, and its economic effects are uncertain. One of the props to the economy has been the influx of money from wealthy individuals abroad to buy property. Mess with this and you could get a currency crisis.

So the government looks trapped. It clearly needs to make radical changes to public services and social insurance, so that these are both more effective and less costly. But this means dealing with social problems at source, working across traditional departmental lines, rather than tinkering at the edges with budgets in the search for marginal “efficiencies” that often cause further cost downstream.

The government has some ideas. It is boosting NHS budgets and hoping that this will enable radical reform to make it more efficient. It wants a drive to renewable energy to reduce energy costs. It hopes that a substantial increase in house-building will lift economic growth (though how putting people in better houses will make them more productive is less clear). It is raising the minimum wage and employer National Insurance in the hop that this will incentivise higher productivity. Each of these efforts (except perhaps the last) is worthwhile but also undermined by compromises. Social care has not been explicitly brought into the scope of NHS reform. Budgets for the energy transition have been crimped. Planning reform is not as radical as it might be. The government seems to be ignoring the implications of raising the cost of lower paid employees on social care – a big driver of health costs.

The government’s luck could turn. This can happen quickly and unexpectedly. But meanwhile, as the FT’s Stephen Bush puts in in a well-written article “Not quite enough may prove to be Labour’s epitaph.” But we should not blame that on Ms Reeves.

Also published on Substack