Learning The Wrong Lessons From Truss
With a UK election two days away, Labour is poised to win handsomely but is taking nothing for granted after 14 years out of power. Part of that involves promising to keep public finances under tight control for fear of risking the wrath of financial markets and investors.
The centre-left party has always had to establish its economic credentials in order to win power and keep the markets onside. Tony Blair and Gordon Brown achieved that to great effect in the 1990s.
This time is no exception and is felt even more acutely after the savage response to Liz Truss’s 49-day premiership in 2022.
After a quickfire budget promising unfettered tax cuts, Truss was forced to resign after a fire sale of UK government bonds which forced the Bank of England to intervene to restore calm. The lesson absorbed by both centre-left and centre-right was that in a world where central bank money creation is no longer anaesthetising the global bond market, no government can spend rashly beyond its means.
Labour’s shadow finance minister, Rachel Reeves, preaches fiscal probity whenever she gets a chance. “The so-called ‘mini budget’ – with its programme of unfunded tax cuts, amidst a concerted attempt to undermine our independent economic institutions – dramatically changed the fiscal circumstances in which we must operate,” she said in her March Mais Lecture, which spelled out her big picture economic vision, and is now required reading.
That may be the wrong lesson for a Labour government and jars with Reeves and Keir Starmer also promising to boost economic growth to fund teetering public services.
As Reeves pointed out, Truss tried to slay a number of investor sacred cows. Unfunded tax cuts were amplified by the promise of much more to come, the central bank was vilified and the government’s fiscal watchdog – the OBR – was shut out of the budget process so could not forecast its consequences. There was no clarity about how and when all this would be paid for. No wonder markets baulked.
The better lesson to learn is investment could be accepted calmly if it is demonstrably going to bolster growth further out, generating higher tax receipts to pay down debt.
“Saying the economy can no longer afford to borrow to invest makes no sense in economic terms, and indeed additional much needed public investment is a key way the UK gets out of its current stagnation,” Simon Wren-Lewis, professor of economics at Oxford University, said. (His blog is also well worth a read)
Blair and Brown adhered to ultra-tight Conservative spending plans for their first two years in government in order not to scare any horses. But that constrained them during their political honeymoon.
In the early 2010s, the coalition government adopted austerity after the financial crisis – again for credibility reasons -- when many economists argued it should instead have borrowed to invest as government borrowing costs were close to zero.
Interest rates are much higher now, so state borrowing is more expensive. But rates will start falling at some point, the recent inflation shock is over, wages are rising in real terms and growth is beginning to pick up.
Extra borrowing could lead to higher market interest rates than would otherwise be the case but there is no reason to presume the markets would seek punitive returns, let alone refuse to lend, if the long-term plan is convincing.
Ah, the counter-argument goes, what about the euro zone crisis where bond markets did shun various states. That was true but once Mario Draghi made clear the European Central Bank would stand behind euro members with his “whatever it takes” speech, the existential crisis was essentially over.
There is no doubt about the Bank of England’s commitment to act as lender of last resort, as it did during the Truss aberration.
As the euro zone grapples with right-wing populism – notably now in France – it is also possible that a UK government with a strong majority offering the stability which has proved elusive in recent years could look relatively attractive to bond investors.
Reeves appears to have clocked that, saying at the weekend: “I want investors to look at Britain and say it is a safe haven in an increasingly turbulent Europe and rest of the world.”
The invest-to-grow argument bites most decisively if it successfully tackles Britain’s long-term low productivity problem. A recent study by the Institute for Public Policy Research showed Britain has been the worst performer, in terms of investment, in the G7 for 24 of the last 30 years. To that extent, Truss was right that we have to break the low-growth cycle.
Labour’s sharp scaling back of its £28 billion green investment plan suggests it isn’t convinced … yet.
But there are glimmers. Reeves has said she would get the OBR to report on the long-term impact of capital spending decisions and use budget statements to show how the health of public finances is improved by good investment decisions – a potential template to convince investors Britain is good to borrow a bit more in the short-term.
Labour’s National Wealth Fund, which is to invest £7.3 billion pounds in infrastructure over the next five years, is a further nod in the right direction.
Labour claims that every pound of public money invested will crowd in three from the private sector but even if you accept the equation, a lot more than £20 billion is going to be needed to rouse Britain’s torpid productivity rates.
Not every measure will cost a fortune. Reform of a cumbersome planning regime would help and foreign investment would probably climb if the new government sought closer trade links with the EU. (That’s a tale for another day if I’m feeling brave enough).
But a lot of money will still be needed to move the dial.
Polls show most people believe taxes will rise after the election, whoever wins. That shows wisdom. But Labour has boxed itself in by ruling out raising the biggest revenue-raising tax rates so the implication is that – whatever Labour says now - borrowing is going to have to be part of the mix too.
If not, it will have to get very lucky, hoping the prospect of stable government and a fair wind will boost growth. Otherwise, the pall that has hung over Britain will not lift. This week’s vote is likely to show how big parliamentary majorities can be wiped in those circumstances.