Rachel Reeves – thinking liberal

Is Rachel Reeves looking backwards or forwards?

Her growth ideas are a blast from the past

I have never really warmed to Rachel Reeves, Britain’s Chancellor of the Exchequer. She hid behind a wooden exterior without revealing anything beyond carefully-crafted PR messages. Still, she was eminently qualified for the job (more so than most of her predecessors) and she has helped transform Labour’s credibility, when her predecessor in the shadow role, Annaliese Dodds, was floundering. I also want to keep my inner misogynist in check: I bristle at a certain type of smartly-dressed, carefully presented, armour-plated, middle-class Labour female politician that has been prominent since New Labour days in the 1990s. I have been giving her the benefit of the doubt.

I forgave Ms Reeves when she announced the withdrawal of the pensioners’ winter fuel payment (or the means-testing of it, to be precise) leading to a blizzard of vituperation. I still think that it is a good policy, even though it is now clear that its political presentation was disastrous. And when she quickly settled many public sector pay disputes I thought this showed evidence of some welcome risk-taking in trying to fix longer-term problems against short-term financial pressures. Her first budget, though, was underwhelming. The only thing that was remotely bold about it was increasing the cost of lower paid employees through adjustments to employers’ National Insurance contributions, and raising the minimum wage. This seems to be a move against employers trying to solve problems with cheap labour. And the budget was sold with a patently dishonest narrative, that the government had discovered a black hole in the country’s finances. The black hole is real enough: but Labour had known its basic contours long before the election: these had been set out by pretty much every intelligent commentator, including, for example, the Institute for Fiscal Studies. Labour simply chose not to call it out.

My reaction to the budget seems to be widely shared – it helped sustain a negative zeitgeist around the economy, which is discouraging investment. Lacklustre GDP statistics (which in reality are pretty meaningless as a performance indicator) supported the negative mood. Ms Reeves has then decided that she needed to lift the mood a bit, with a string of public appearances pushing the idea that the government will not compromise in its search for growth. The good news is that this extra exposure at last seems to be breaking down her woodenness and she has been more inclined to answer questions rather than just spout pre-prepared sound-bites. The bad news is that what she is communicating is pretty disappointing.

Clearly Ms Reeves is anxious to get across the message that the government is really, really keen to encourage investment by reducing red tape. This is a popular theme right now, with the Trump administration trumpeting the message in America, and The Economist has a long article on the subject this week. I have a lot of sympathy. Most regulation is badly designed and implementation is usually even worse. Bureaucrats (in both private and public sector) lay on cautious over-interpretation, and then spend their time chasing innocent minor infractions and slowing down worthwhile projects, rather than tackling the harms that the regulations were designed to prevent. Sometimes this is a necessary evil, but surely we should aspire to do much better. Alas, all this is popular thing for government ministers to say, but there is a huge creditability gap, as they rarely deliver anything worthwhile. And that is especially true of Labour politicians. Their core supporters adore regulations (they are often the ones tasked with managing them) and any worthwhile deregulation hits stiff political resistance. Ms Reeves clearly knows this and realises that she needs to make an unpopular gesture to show that she means business. So she chose airport expansion, and expansion of London’s Heathrow airport in particular.

This has a great deal of symbolic value. Heathrow expansion has been a political football for as long as I can remember. Its advocates have always justified it in terms of “growth”, and there is a fierce NIMBY opposition. These can be presented as London elitists – but there are no obvious beneficiaries to the project outside the country’s richest region. Driving this through would be a signal achievement, showing that the government really does mean business.

There is a plausible economic case to be made for expanding Heathrow – The Economist makes an attempt this week, based on its value as a hub airport for Europe. Ms Reeves failed to make it on her media round. This included an extended interview with Justin Webb for the Today Podcast. In it she insisted that the potential impact on carbon emissions has been neutralised since it was last reviewed by the use of biofuels. Well there are ambitious targets for the greening of aviation fuel globally – but these lack credibility and look more like a smokescreen for the aviation industry. There is no way that Britain’s pressurised agricultural sector could produce these fuels itself. The Economist doesn’t even try to suggest this (though another article suggests that Brazil might turns itself to this fuel, if it can find sufficient investment); it just says that the use of electric ground vehicles (a lot of the pollution comes from the ground, apparently) and the diversion of flights from other other ports mean that the impact on carbon emissions is reduced. I don’t understand why Ms Reeves chose to make her central argument on such tricky ground.

I am personally unconvinced by the economic case for Heathrow expansion, even though it is no longer in my backyard (though Gatwick is, but that’s another story). I have a more quotidian worry. The new runway would cross London’s orbital M25 motorway, which would have to go through a tunnel underneath. The western M25 is a critical road artery (pretty much unavoidable if you want to travel to western parts of the country from here in East Sussex); it has already been badly disrupted by the rebuilding of its A3 junction. That work will barely be finished before it would again be disrupted by the construction of the tunnel. That will have its own impacts on economic activity. That’s small beer – but the prospect of re-launching the expansion programme for the managers of Heathrow remains a very daunting one – and notwithstanding government support for the next 4 years – they may not be willing to risk another failed project.

What is striking about Ms Reeve’s dash for growth, though, is how retro it looks – and not just Heathrow. The infrastructure projects are concentrated in the already prosperous South East (including two more airport expansions) and the government promises to play fast and loose with environmental objections. Gone is the idea of “Levelling up” or a “Northern Powerhouse”, to try and secure growth by helping less prosperous regions catch up. These ideas were admittedly Tory – but they helped keep the so-called Red Wall of seats in the North, Midlands and Wales in play. Labour won these seats back in their landslide, and it is striking that the government is leaving them out of its flagship programme, given that these same seats are subject to a surge of support for Reform UK. But it represents economic orthodoxy (the prevailing culture in the Treasury after all) – and thus the government’s seriousness about the whole thing.

That’s striking because the government is still pushing back against two other bits of orthodoxy. It won’t seriously engage with the EU about substantive trade integration for fear of reopening the Brexit wounds (this time in deference to that Red Wall). And it continues with its ambitious strengthening of workers’s rights; orthodox economics would suggest that this will discourage investment. Businesses are now hoping that they can pressure the government into watering these down. They may well make headway.

All this is rather depressing. Some of the ideas are perfectly sound, and it would be really encouraging if the government could push them through – the Oxford-Cambridge corridor (including rebuilding a railway line stupidly closed by Beeching in the 1960s, in accordance with the then economic orthodoxy), and a further lower Thames crossing. But a retreat into old-fashioned orthodoxy feels like the government is trying to revive a lost past, rather than providing a vision of a hopeful future.

Perhaps that’s unfair. The government is desperate to try and create a more hopeful zeitgeist. Attempts to try and paint a more hopeful and optimistic vision, around green energy for example, have fallen flat in its absence. One of the government’s ideas for regional development involves reorganising local government. also the government sets great store by the gutting of planning laws (and the local government reorganisation into bigger units may also have the aim helping drive through planning applications). These will take time to yield results. Ms Reeve’s budget will increase public spending over the next year, and this should rev things up a bit. Once the mood shifts to something better, it may be time to be a bit bolder.

Perhaps so, but my abiding impression is of a Chancellor who lacks a bold vision of a new, modern economy, and is unduly reliant on the conventional wisdom of her Treasury civil servants. I hope I am wrong.

First published on Substack

A Budget that poses as many questions as it answers

This week Rachel Reeves, Britain’s chancellor of the Exchequer, delivered the first strategic Budget the country has had since George Osborne’s in March 2016, unless you count Kwasi Kwarteng’s short-lived effort in Autumn 2022. Mr Osborne’s effort was, of course, simply maintaining the strategic course he set when he first became Chancellor in 2010, and on which doubled-down in 2015 once he’d dispensed with his Liberal Democrat coalition partners – a strategy usually referred to as “Austerity”. That was to shrink of the British state’s footprint, reversing the trend established by Labour, especially from its second term starting in 2001. Ms Reeves is reaffirming the role of the state, but whether that is simply consolidation or a decisive expansion remains unclear. What is over is the firefighting, bluff and pretence of the years 2016 to 2024; there is now a serious engagement with the challenges confronting Britain.

Mr Osborne’s budget of 2016 was quickly overwhelmed by the Brexit referendum in the following June, which saw a new prime minister, Theresa May, and Chancellor, Philip Hammond. They rejected the Osborne strategy with a turn against Austerity. But the mess left by the referendum result was not conducive to clear strategy, as nobody really understood what the result meant. Was it the creation of a small-state “Singapore on Thames” as many senior Brexiteers wanted, or just a grumpy turning inwards? Any chance of the new government coalescing around a coherent strategy was destroyed when it lost its majority in the snap election of 2017. A new government emerged under Boris Johnson in 2019, but his strategy was to have his cake and eat it – to avoid any difficult choices: a strategy not to have a strategy. Liz Truss and Mr Kwarteng took over in 2022, and although they did appear to be strategic, their efforts collapsed almost before they had started. The Rishi Sunak and Jeremy Hunt regime’s only strategy was to try to survive until their political fortunes turned. They pushed through cuts to National Insurance based on fictional forecasts of future government spending. It was fundamentally unserious.

Labour’s first job after taking power in July was to restore those public spending estimates to some kind of reality, without sparking the kind of panic over fiscal probity that Mr Kwarteng had done. They made this job much harder because they chose to humour the Conservatives’ fiction on the public finances rather than challenge it. They promised not to raise taxes on “working people”, and specifically not Income Tax, National Insurance or Value Added Tax. Since taking power they then suggested that they had discovered a surprise “black hole” of over £20 billion, or perhaps £40 billion. But mostly this was known about before the election – and repeatedly pointed to by the Institute for Fiscal Studies. But no political party addressed the issue properly – not the Lib Dems, Reform UK or the Greens, never mind the main two parties. All said that public services could be maintained based on implausible taxes on other people, or equally implausible cuts to benefits. Ms Reeves decided that raising employer National Insurance was not too egregious a breach of election pledges, and went for that. This raises the overall tax take to its highest ever level as a ratio to income, but well within European levels. Whether this really means the largest extent of the state ever, I suspect, depends on how you treat benefits, which is more of a negative tax than a part of the state apparatus, and which have been steadily creeping upwards. But looking ahead beyond the next two years, Ms Reeves continued her predecessors’ fictions on public spending, and cut safety margins to nothing, in order to demonstrate medium term financial targets were being met.

That was because the Office for Budget Responsibility (OBR) forecast meagre growth. Labour’s plans had always been based on improved economic growth – but they cannot give the OBR anything solid enough to raise their forecast. A lot of growth comes from the zeitgeist, out of reach to policymakers and economic forecasters alike. And many of the government’s pro-growth policies have yet to be worked out. Landing a big extra tax burden on businesses in the short term, moving to workers medium term, leaves a bit of a credibility gap there, and it’s hard not to think that Ms Reeves is relying on a positive change to the zeitgeist to get her out of the hole.

Still, the government was never going to solve its economic challenges in one go. This budget is seen as a necessary first step, setting a credible baseline from which to move forward. To me that is a convincing enough narrative, but one that clearly leaves many questions. I have already mentioned growth. Social care is an issue that overshadows all health and welfare spending – and even the Tories attempted to tackle it on occasion – but it has so far been ignored by the government. The government wants to increase the efficiency of government services – but so has every government I can remember: what makes this time different? And many stretched government services, notably those within the remit of local government, are getting little if any extra funding: how sustainable is that?

The one thing going for the government is that expectations are dismal – it will not be so hard to beat them. They aren’t making the mistake that Mr Johnson made in 2019. A good run of luck could change the climate completely.

For me the jury is still out on this government. This Budget isn’t a bad start by Ms Reeves, but many more tests are to come.

Labour’s dishonesty at the election is catching up with it

05/07/2024. London, United Kingdom. The Prime Minister, Sir Keir Starmer and his wife Victoria arrive at Number 10 Downing Street upon his appointment. Picture by Kirsty O’Connor/ No 10 Downing Street

Sir Keir Starmer, Britain’s Prime Minister, can be summed up in a single word: Focus. He is learning the problems that this characteristic brings. His focus on winning the election on 4th July has made his life much harder now that he has won. Labour has made an awkward start to its term of office.

In government Sir Keir’s focus is on five “missions”. This is an admirable approach compared to the chaos of Conservative governments, especially since 2016. We can quibble about the design of those missions: number one is “kickstart economic growth”. Growth makes a poor target: it’s both a bit like targeting happiness, which is something that happens when your are trying to achieve something else, and a bit like targeting the birth rate, which just isn’t under state control. It is under this heading that housing is being tackled: much better to have targeted housing specifically, surely. Social care doesn’t make it into the five – which cover the energy transition, law and order, education and the NHS (or in fact health) – but which of the others would you drop? Neither does immigration, which would have featured in any Tory big five – but that is more understandable. Focus is integral to achievement,- but it comes at the expense of risk management. A lot of the skill of management is learning how to balance the conflicting requirements of focus and risk management. Sir Keir must not be too relentlessly focused – he needs to have a strategy for dealing with the many other issues that have the potential to derail. He needs to use trusted colleagues for this.

What Sir Keir had clearly hoped was that the sight of a government clearly focused on achieving the nation’s priorities would present such a contrast to the previous government that he would have a prolonged honeymoon – especially as there is no coherent opposition. That has not been so. The summer’s big unforeseen event was the rioting that followed the Southport murders – but these played to Sir Keir’s strengths. A strict no-excuses crackdown was what the public wanted and this was delivered without hesitation. But from this emerged a big problem: neither he nor his most important colleague, his Chancellor of the Exchequer Rachel Reeves, are good communicators. They are wooden in their presentation and in their responses to questions. This has not helped them in their presentation of bad news about the government finances, the need for continuing austerity, and in particular the cancellation of the winter fuel allowance for all but a few state pensioners, just as fuel costs were rising again. They are blaming this on the previous government covering up a black hole in the nation’s finances -but this is coming across as insincere. Not without reason.

The problem is that the “black hole” in government finances is not at all surprising – so acting surprised looks fake. Throughout the election campaign the Institute for Fiscal Studies, a well-respected think tank, complained that all the parties were painting too rosy a picture of the nation’s finances. It really wasn’t hard to see why. The previous government was trying to use inflation to squeeze public sector costs – and noticeably force down the real pay of public sector workers. On this basis they fairly transparently cooked official forecasts that they could make cuts to National Insurance – even after they had tried to raise the tax in 2022. But Labour were silent about all of this, choosing not to challenge the Conservative’s general policy direction. Both parties seem to have been obsessed by the thought that the 2024 election could be a repeat of the one in 1992, where the Tories successfully built a campaign on “Labour’s Tax Bombshell” that turned a seemingly inevitable victory for Labour into defeat. Labour promised not to raise any of the main taxes (Income Tax, National Insurance and VAT), matching a Tory promise and said they would match Tory spending projections except in a few specific places. They were evasive on the clear implication (highlighted by the IFS) that this meant austerity in most aspects of government spending. Sir Keir’s focus was on winning the election with an outright majority, and he wanted to leave nothing to chance. If he was being dishonest, then he was no more so than the Tories, the thinking g seems to have been.

But, as my mother used to say, two wrongs don’t make a right. Labour could have been more honest about the state of the nation’s finances before the election, and they weren’t. The focus on winning the election has made the task of government much harder. Sir Keir has been desperate not to repeat the Tory habit of over-promising and under-delivering, and has been caught out over-promising. He is, of course, trying to pin this on the previous government, in the manner that David Cameron’s coalition government pinned the blame for its austerity policies in 2010 on the previous Labour one. But Mr Cameron, his Chancellor David Osborne, and even his Lib Dem deputy, Nick Clegg, were all much better communicators than Sir Keir of Ms Reeves (not that this did Mr Clegg any good…). Their hopes rest on the fact that with the next election four or more years away, some more positive events may have overtaken this difficulty.

I am disappointed. I had allowed myself a brief moment of hope. The speed with which the government settled the various public sector wage claims seemed to show a degree of imagination. They must have overcome firm Treasury pushback that “we can’t afford it”. But the better country that they want to bring into being features a happier public sector workforce, and better pay for the bottom and middle quartiles, and less dependence of cheap overseas immigrant workers. Squeezing public sector pay, with no plan for when any catchup might happen, is just takes the country further away from this goal. This is the reason I think that Jeremy Hunt, Ms Reeves’s predecessor, was one of the most disastrous Chancellors of recent times. He swallowed the Treasury logic on payrises and then made things worse with tax cuts.

But that flicker of hope has been suffocated. No evidence of such a degree of long-term vision has emerged. Instead the story was that the urge to settle the disputes was because they were unpopular and a distraction, and the previous government could be blamed. I was particularly disappointed that the government allowed the Treasury to defer the previous government’s plan to tackle the growing social care crisis, for the nth time. The government has to stick to its promises on tax, and social care didn’t make it onto the big five priorities. But the long-term consequences are not good, and some kind crisis is in the making. Labour’s focus on the election is making the challenge of decent long-term government harder.

Still, it isn’t all bad news for the government. None of the contenders for the Conservative leadership look capable of leading a revival for that party. The rift on the right, with the success of Reform UK, looks as if it will do for Labour what the rift on the left did for Mrs Thatcher in the 1983 and 1987 elections – enable landslide victories on the basis of lacklustre vote share. And the Lib Dems show some of the same problems as Labour. A relentless focus on doing well at the election at Tory expense leaves them ill-equipped to tackle Labour. The prospect that Sir Keir will get a second term remains good. The mandate that he seeks at that election will be critical to the success of his project overall. He needs to give himself much more room for manoeuvre.

PS Other commitments mean that this will be my last post for at least a couple of weeks. I plan to resume after the Lib Dem conference with my thoughts on what that party should do next.

National finances don’t work like household budgets. That doesn’t help Labour

Government finances are under water. OK, a weak link but I’m bored of AI images and public domain photos. Bosham in Chichester Harbour this weekend, by my own hand.

Taxation and public spending is very much on the political agenda here in Britain. The Chancellor of the Exchequer, Rachel Reeves, is claiming that there is a £22 billion black hole of unfunded spending commitments in the government finances, left by a Conservative government addicted to brushing problems under the carpet. There is much talk of how her Labour government might raise taxes to plug this hole and meet expectations of improvements to public services and the social safety net.

This makes it a good time to ponder the economics of all this. Public debate encourages us to think of the state’s finances in terms of a household budget: public spending must be covered by taxes, or else the national debt gets out of control, which in due course could mean throwing the country to the mercy of foreign creditors, or burden future generations. This narrative has the merit of being easy to communicate and sounding like common sense. Try telling voters that this is not how things work, and they will immediately become suspicious. The US Republicans, to my knowledge, are the only politicians to have succeeded with a different narrative: the so-called “Laffer curve”, whereby tax cuts pay for themselves through economic growth. Former British Prime Minister Liz Truss tried this out on the British public in 2022, but it went very badly. Her supporters argue that his was actually through bad luck – but most politicians now treat the idea of “unfunded” tax cuts or spending commitments as politically toxic, as well as economically unwise.

The Laffer curve is in fact just one argument against the household budget narrative – but it is not a huge departure from it. Households may borrow to invest, so states should be able to so as well. If a budget deficit leads to a future increase in revenues, or lower costs, then surely it is sustainable? Labour tried to make this case with a proposal for massive investment in clean energy infrastructure – but lost their nerve as the general election loomed. Joe Biden’s administration is actually implementing such a programme in America, but the public there are resolutely sceptical. You have to believe that the future benefits are for real – and the public is generally unbelieving. Not without reason, as the processes of accountability are weak.

A further, and well-established, argument against the household budget narrative might be called the Keynesian critique. This follows the argument originally put forward by the great economist Maynard Keynes, after stringent budgeting by governments during the Great Depression of the 1930s made things worse. If there is spare capacity in the economy – a typical feature of recessions – then it makes sense for the government to run a deficit to raise demand and employ unemployed workers, creating a virtuous circle of growth – and stopping a potential doom-loop of savings leading to reduced demand leading to further savings. Governments should use taxes and spending to help manage overall demand, to ensure that the economy runs at an efficient level of capacity. This idea is very popular on the political left, who generally assume that the economy is always working below capacity – but it is not always easy to tell if there is spare capacity. Many people thought that high unemployment in the 1970s meant that there was spare capacity then – but generous fiscal policy simply seemed to stoke inflation – “stagflation”. In fact the escalating price of oil, amongst other things, meant that the economy was in a period of transition, which caused the high levels of unemployment without a ready supply of potential new jobs. I thought something similar was happening in Britain after the great financial crisis of 2007-2009 – and that this was the justification for the 2010 coalition government’s austerity policies (which were rejected by the left with religious fervour). The pre-crash economy had been too dependent on fake gains in financial services and related business services, meaning that it wasn’t just a case of managing aggregate demand, but allowing for a degree of restructuring, which takes longer. I don’t think anybody else made that argument. Supporters of austerity used versions of the household budget narrative, while most economists said that austerity was the wrong policy because aggregate demand was weak. I still think I was right – though by 2015 the case for further austerity had largely gone, meaning that further cuts made by the Conservative government from that year were excessive.

A final critique of the household budget narrative is made most prominently by advocates of Modern Monetary Theory (MMT). They point out that where countries control their own money supply (which is the case for Britain and America, though not the Eurozone), then they don’t need to worry about the national debt, because they can just create the money to fund it. This, in fact, is exactly what many governments did during the period of Quantitive Easing (QE) in the 2010s. For some reason, MMT is regarded as heterodox economics, and its advocates akin to heretics by conventional economists. I have never entirely understood this – it has always seemed to be a matter of politics rather than substance. Some MMT advocates delight in attacking orthodox economics, not always with secure logic, and this no doubt creates a backlash. Nevertheless MMT economists such as Stephanie Kelton produce well-argued work which is thought-provoking in a good way (this article in the FT gives a flavour). The central proposition is that the limiting factor for fiscal policy is inflation, not debt. While inflation in the developed world appeared dead and buried in the 2010s, MMT became popular on the left, as it suggested that large budget deficits were sustainable, supporting their argument that austerity policies were primarily “ideological”. In the 2020s, with inflation back in the picture, we don’t hear so much about MMT, though their analysis remains just as valid. My personal scepticism of MMT is that its advocates don’t tend to think enough about the difficulties of managing a small open economy, which has to manage its economic relations with other economies (and exchange rate policy in particular) – a situation that fits the British economy more than the American one.

What all these insights point to that there are two important constraints to fiscal policy rather than simply whether there is enough money: inflation and foreign debt (if we accept the MMT argument that domestic debt isn’t a problem if inflation is under control). Low inflation is central to a country’s feeling of economic wellbeing. I would suggest that maintaining the value of the currency is one of the sacred duties of the state – and governments play fast and loose with this at their peril – though most liberal economists are more relaxed about this. And foreign debt can interfere badly with a sense of national sovereignty. The reason that the recent left-wing Mexican president Manuel Lopez Obrador was so keen on limiting government expenditure was exactly that: a fear of foreign debt (and an example of how austerity is not always a matter of right wing ideology). Where governments have dormant inflation and little need for foreign debt (through a current account surplus), then budget deficits can run wild – this is the case with Japan, for example. In Britain things are considerably trickier. The country now has an inflation problem, and a long persistent current account deficit, which complicates managing the national debt. It is hard to know how much of a constraint the latter problem actually is. It hasn’t been tested to destruction since the 1970s (if you discount the Truss episode), when the government called in the IMF, though some suggest this was just political theatre. The country has had no trouble in financing itself from abroad in its own currency. The country’s dependence “on the kindness of strangers” is a popular scare story put up by officials of the Treasury and the Bank of England to keep politicians in their place. And yet, like inflation in the early 2020s, you don’t know if you’ve gone over the limit until it’s too late. It was a debt problem that did for Ms Truss’s bid for freedom, after all. That was a dislocation in the domestic debt market because of some technical issues with pension fund financing. I have oversimplified things by referring to “foreign” debt – but the presence of foreign investors affects the disciplines required across the whole market. That episode showed that management of the national debt has to be strategic – it is not a simple matter of ramping up a budget deficit and seeing what happens.

Meanwhile, I suspect that inflation in Britain remains a serious problem, in spite of the headline rate returning to 2%. In the public sector the government is no longer able to resist above-inflation payrises: you can only defy the market for so long – this is a large part of Ms Reeves’s black hole. That may ripple through to the wider labour market, as the previous government feared. Meanwhile there is enormous political pressure to reduce levels of immigration – and it isn’t just politics: high rental and property prices, in part driven by immigration, is causing serious hardship, and disappointed expectations amongst younger people. Politicians talk of encouraging a high-wage high-productivity economy, not dependent on cheap immigrant labour, and it might be that the country is in transition to just such a destination. But all economic transitions involve bumpy rides, and inflation is often part of that journey. That matters because under the country’s current economic governance, the Bank of England will not reinstitute QE, and make government debt easier to swallow, when there is a threat of inflation. And while reforming economic governance might be a good idea, in the short term it would carry a heavy risk of the destabilisation of financial markets.

So, with a clear menace of inflation, and more difficult markets for government debt, the government is likely to have to raise taxes. And here politics has created a further problem. Easily the most effective taxes are Income Tax, National Insurance and Value Added Tax. These are effective because they have a large base, meaning that small percentage increases have a big impact, and because they have the most direct impact on aggregate demand, helping the management of inflation. And yet Labour has ruled out increasing these taxes (other than through the “stealth tax” of freezing tax-free allowances). There was, in fact, a political consensus on that policy: no party is suggesting that there should be any increases – which is seen to add hardship to those already suffering from higher inflation. That leaves various flavours of capital taxes or wealth taxes. These have the political advantage of primarily affecting the better off, but they help with the national debt rather than inflation – their impact on demand is limited. And they are often evaded by people with tax advisers. That is the big problem with the idea, popular on the left, that increased state spending can be financed just by taxing the rich – such a policy would be inflationary and likely to underperform its targets.

Something has to give. The government will struggle on with continued austerity and increasing some fringe taxes, hoping for a growth bump. But growth is bound to disappoint, inflation will refuse to die, and interest rates will remain uncomfortably high. One commentator has written that it will not be until a second term that Labour will start to seriously address how the country manages the state – through some combination of higher (and doubtless reformed) taxes and reduced state ambition. If the Conservatives remain in a mess, that may become politically feasible. Up until now Sir Keir Starmer’s aim has been to secure an election victory, and to impose a more serious style of political governance. That is a start but it is not enough.

As the Tories implode, do the holes in Labour’s position matter?

In my last post, published on Sunday, I suggested that the British prime minister Liz Truss and her Chancellor Kwasi Kwateng should have been pleased with how their budget was going down. The messaging was clear, and the opposition response muddled. By Monday, though, the story had moved on. Bond and currency markets were giving the statement a spectacular thumbs down, and there was a whiff of panic in the air. The panic has passed, but it is evident to almost everybody that the pair have dug their party into a very deep hole. Today the Bank of England announced that it would be forced to finance a portion of government debt through money creation. It’s not a good look.

The market rout begun on Friday, especially in the gilt markets – but on Sunday Mr Kwateng clearly felt things were going well enough to double down on his tax cutting plans, and suggest there were more cuts to come on. But by Monday he was forced to try and calm things down, with promises a proper plan for national debt. Faithful supporters have been doing their best to mount a rearguard action, though no minister has put their heads above the parapet. They have tried to deflect the currency problems onto the US dollar, which doesn’t explain the sharp devaluation since Friday, evident against even such currencies as the Turkish Lira. All suggested that there was more to come to make things better. Tory MP Andrew Bridgen suggested the government might like to cancel the flagship HS2 rail project; John Redwood, a veteran MP who is somewhat more economically literate, said that the government was about to reveal a tranche of supply-side reforms, so the markets hadn’t seen the full picture. These messengers were helped (on BBC radio at least) by the lack of economic grip of their interviewers, who did not press them on the obvious gaps in what they were saying. The BBC also helped when remarkable criticism came in from the IMF, by highlighting their comments on inequality -rather that the much more damaging criticism that the budget threatened to create a recession rather than head it off.

The darkening mood was no doubt caused by the prospects for mortgage rates. The reason that markets stabilised was that traders came to appreciate that interest rates would go up in reaction to the budget. Mortgage providers reinforced this point. Commentators quickly showed that increases to mortgage payments for homeowners would quickly overwhelm any extra cash coming from tax cuts. And this is a critical group to Conservative electoral prospects. The criticism by government supporters of the Bank of England not raising interest rates earlier (“asleep on the job” according to Mr Bridgen) doesn’t really help here. Once the government’s ability to finance itself comes into question it has no attractive option to dig itself out. Monetary financing at a time of inflation is hardly going to stabilise things. Reversing the tax cuts would be a humiliating retreat which could taint the Conservatives for a generation. Spending cuts on the scale needed would alienate a large part of the party’s base, as would letting interest rates rip (though a different part of that base). Supply side reforms would have to be big and spectacular to reassure markets. Release immigration controls? Re-enter the EU Single Market or Customs Union? Stop Russian sanctions and invite oligarch money back?

What makes things worse for the government is that they were warned well in advance. During his leadership campaign former Chancellor Rishi Sunak warned Conservative Party members that handling the energy crisis and making tax cuts did not go together. Ms Truss poo-pooed this as “Treasury orthodoxy” which had ended up in years of sub-standard growth. There is certainly a baleful aspect to Treasury orthodoxy that requires intelligent challenge – but the Treasury also has experience of navigating the treacherous world of government finance. FT columnist Janan Ganesh says that the government has fallen into the trap of trying to apply policies appropriate to the United States to a medium-sized archipelago whose currency is not used as a global reserve. Success in running British economic policy is a delicate balancing act which depends on maintaining confidence, not thumbing your nose at the rest of the world.

What of Labour? They can hardly believe their luck. The initial response was fumbled. They went on about the tax cuts for the rich (and the abstract idea of “trickle-down economics”) – leaving the much bigger charge of being reckless with the country’s finances muted. But by Monday, with their party conference in progress, they started to find their feet. Their shadow chancellor, Rachel Reeves, delivered a worthy speech, in which she gave emphasis to financial stability. She also started on an alternative growth narrative that did not depend on tax cuts – through green investment and such. It is important that the Tories are not allowed to win the growth argument by default, of which there was a distinct chance, so ruthless and repetitive has been their messaging.

This has been complemented by an orderly conference, with its leader, Sir Keir Starmer, clearly in control. Dissent has been modest. I listened to two interviews by senior members of the party’s socialist wing: John McDonnell and Diane Abbott. Neither created trouble (and Mr McDonnell was distinctly more in command thad than Ms Reeves). The party was able to develop a narrative of a government-in-waiting.

Still, there are two big problems with Labour’s stance. The first is that they lack an alternative fiscal policy. They only said that they would reverse the higher rate tax cut, which has little fiscal impact – and said would not reverse the national insurance and basic rate income tax reductions. So how would they try to fill the evident gap? We just got obfuscation. When challenged about how the party was would maintain spending on the NHS and social care, Ms Reeves suggested that there was no problem because Mr Kwateng said so. They are trying to accept the fiscal package and disown it at the same time. To be fair, they did not say anything about not increasing Corporation Tax, and they have suggested higher windfall taxes on energy companies. But surely they are going to need something more. Tony Blair and Gordon Brown, who the leadership would like to emulate, solved a similar problem in the mid 1990s by adopting an austerity stance on spending – shadowing the Conservative government’s spending plans. This would take the party out of its comfort zone – but something like this will surely be necessary.

The second big problem is engagement with the European Union, as pointed out by Danny Finkelstein in The Times. The party understandably does not want to reopen the Brexit debate. But how to create a credible path for the country outside the union while shadowing so many EU policies on worker protection and the environment? This surely creates a competitive weakness. Mr Finkelstein thinks that the party, once in power, would surely be forced into a closer trading relationship, sacrificing many of the sovereignty gains as a result.

So Labour is trying to have its cake and eat it. Boris Johnson could get away with that, but it is harder to see that Sir Keir can. However the hole that Ms Truss has dug for her party is so deep that it probably doesn’t matter.

UPDATE, 30 Sep 22. The first quarter’s current account deficit was reported by the FT as being over 8% – compared to the 3% figure which I took from The Economist. According to the FT report (which dated from before the statement), this was making gilt markets nervous. This makes sense, though I would prefer to know exactly where the funding vulnerabilities are rather than relying on these broad aggregates. All this shows that there was lots of evidence that Mr Kwateng (and Ms Truss) were skating on very thin ice before the statement, but they chose to ignore it. Mr Kwateng’s decision to keep on digging the hole deeper in Sunday media interviews is quite astonishing.