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The economic challenge facing Labour is enormous. But it is also straightforward: Britain has experienced a prolonged period of weak growth, public services have been starved of cash and are struggling, and the state of the country’s infrastructure is a disgrace.
The government is holding a global investment summit in London on Monday, yet for all the hype this is unlikely to prove a gamechanger. Business investment in the UK is the lowest in the G7 and has been for 24 of the past 30 years. Conclusion: the government needs to invest – and invest big – to mend, grow and future-proof the economy.
But not so fast. It may be desirable for Britain to have shiny new hospitals and a modern power network to bring renewable energy to the cities, but only if the financial markets give any plan the thumbs up.
There has been speculation that the City could go on strike in the event that investors don’t approve of what Rachel Reeves comes up with on 30 October. If the budget involves too big an increase in borrowing to fund infrastructure projects, then the markets may refuse to buy UK bonds and this will lead to higher interest rates. This discipline will force the government to come up with plans based on what the markets will accept, not on what the UK might need.
The risk of a buyers’ strike is exaggerated. The interest rate – or yield – on 10-year UK gilts has certainly increased since Reeves said her plan was to “invest, invest, invest”, but the budget is only part of the story, and a relatively small one at that.
The rise in UK bond yields is in line with what’s been happening to 10-year US Treasury bonds over the same period, and in both cases has been largely due to the markets now expecting that interest rates will be cut less rapidly due to improved growth prospects.
As Kallum Pickering, the chief economist at Peel Hunt notes, in the past few weeks Brent crude oil prices have risen by about 8%, while natural gas prices are up by 10%. Bond yields in every G7 country have risen in response to the prospect of a modest increase in inflation caused by higher energy prices: in the US and UK by about 0.5 percentage points, by 0.4 points in Canada, by 0.2 points in France, by 0.15 points in Germany and Japan, and by 0.1 points in Italy.
Yes, bond yields in the other European members of the G7 have increased by less than they have in the UK, but that has much less to do with the prospect of a “buyers’ strike” and much more to do with the fact that the eurozone economy is heading for recession. UK growth and inflation has cooled, but not by as much.
All that said, Labour governments have been wounded – sometimes fatally – in past encounters with the financial markets, and Reeves is keen to avoid confrontation. Gordon Brown was able to win the Labour government of 1997 brownie points with the City by making the Bank of England operationally independent; George Osborne did the same for the Tories by creating the Office for Budget Responsibility in 2010.
These options are not open to the current chancellor, and therefore Reeves plans to do two seemingly contradictory things at once: change the borrowing rules so she can spend more on capital projects, while at the same time raising taxes and curbing spending so that the government’s current budget – its day-to-day operations – is balanced. Reeves believes this approach is tougher than that of the previous Conservative government, and makes better economic sense.
One thing is certain: the impact of the tax increases and the spending curbs will have a more rapid impact on the economy than the increase in investment. In a sense, this is inevitable given the need to identify the projects for a major programme of public works, to rank them in an order of priority, and to deliver them on time and on budget. This – given the shrivelled capacity of the British state – will not be easy.
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The risk, therefore, is not that the budget is too generous but that it is too restrictive, sucking demand out of the economy at a time when it is already showing signs of slowing down. Warnings from the chancellor and the prime minister about the dire state of the public finances have dampened business and consumer confidence, and while there is the chance that the budget goes down well because it is less draconian than expected, there is no guarantee of that. It would help Reeves were the Bank of England to start cutting interest rates more aggressively.
Being chancellor in today’s circumstances is not an easy gig. In July, the public voted to end austerity and for higher public investment, yet the government’s ability to fulfil its mandate relies on securing approval from the financial markets.
Keynes said that finance should be the servant not the master, providing a steady and reliable source of funds for investment and not much else. In the decades after the second world war strict capital controls usually ensured that was the case.
The opposite now applies. Finance is the master not the servant. It decides what governments are free to do; it sets the terms of the debate; it shapes and dominates the economy.
Too bad, you might think. That’s the way it is. But the reality is that, without curbs on finance, governments are severely constrained in what they are able to deliver, even if they have a powerful mandate. The triumph of finance has not been good for democracy. It has not been good for the economy either.