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