The UK economy has been grappling with stagnant growth for several years, a trend mirrored by many developed nations. Since the 2008 global financial crisis, the country’s average annual growth rate has stagnated, significantly impacting living standards.
Economists often highlight a stark reality: real wages in the UK have experienced minimal growth over the past 16 years, marking the worst stretch in over a century. Clearly, action is required.
Rachel Reeves is fully cognizant of this pressing issue. When asked about potential remedies for the UK’s economic woes, her response is unwavering: an emphasis on investment.
Her upcoming budget announcement on Wednesday is poised to be the most significant since the emergency measures introduced by David Cameron and George Osborne in 2010 when they led the new Conservative coalition government. This budget is vital not only for jump-starting tax and spending strategies under Labour’s first administration in 14 years but also for stabilizing the party’s declining popularity.
The chancellor is proposing around £40 billion in fiscal adjustments, primarily through tax increases, with capital gains tax and employers’ national insurance contributions earmarked as major sources of revenue. This tightening will be balanced with a boost in public investment spending, potentially focusing on essential infrastructure projects, such as railways, bridges, and green energy initiatives.
Combined, these initiatives could make this budget the largest in monetary terms in three decades.
A proposed £20 billion increase in government investments will be supported by a financial restructuring that compels the Office for Budget Responsibility (OBR) to evaluate a broader scope of government assets and obligations when projecting public finances.
This adjustment to fiscal regulations—likely involving public sector net financial liabilities (PSNFL) instead of just public sector net debt (excluding Bank of England holdings)—should provide the chancellor with the flexibility to borrow an additional £50 billion.
By accounting for a wider array of public financial assets under PSNFL, such as student loans and government stakes in companies, the debt-to-GDP ratio may be reduced at a quicker pace compared to traditional metrics.
The extent of her investment spending and its perceived effectiveness will be critical in determining whether Reeves can gain the favor of bond markets. She must persuade both investors and the OBR that this approach will stimulate growth.
The UK’s historically low investment levels have hindered economic progress, resulting in the nation consistently trailing behind other affluent countries. Since 2000, the UK has ranked among the lowest in public investment according to the Organisation for Economic Co-operation and Development (OECD).
This lack of investment is partially attributed to a series of capital spending cuts implemented by Conservative chancellors to adhere to fiscal regulations over the past 14 years. Eliminating projects that haven’t yet commenced is often viewed as a more politically viable option than raising income taxes.
Plans initiated by Jeremy Hunt in this year’s March budget indicated a decline in government investment from approximately 2.5% of GDP this year to 1.5% by 2029/30, translating to about £20 billion annually—equivalent to Hunt’s four percentage point reduction in national insurance contributions.
James Smith, research director at the Resolution Foundation, commented, “The government should take the lead by improving the UK’s position in the OECD rankings for public investment. Doing so can spur direct growth while also attracting more private sector investment.”
Lord (Jim) O’Neill of Gatley, a former Treasury adviser and chief economist at Goldman Sachs, argued, “Investing through borrowing is not just beneficial; it is crucial for this government with its growth objectives. With the protracted issue of low investment spending in the UK, the government must exhibit genuine ambition as the most patient investor. “
A recent report from the OBR provided a tacit endorsement for increased public investment, suggesting that a sustained rise in public investment by 1% of GDP could elevate the economy’s potential output by 2.5% over 50 years.
Similarly, the International Monetary Fund (IMF) has expressed optimism regarding heightened capital spending, asserting that it not only boosts economic output in the short and long term but also encourages private investment and lowers unemployment, with minimal impact on public debt ratios.
However, increased borrowing carries risks. Governments can misuse taxpayer dollars, and higher borrowing could elevate interest rates, discouraging private sector investment. Projects may also be halted before completion, incurring substantial costs (as demonstrated in the HS2 case).
With Labour’s substantial majority in Parliament, the main challenge it faces during the budget is managing bond market reactions—a powerful influence that previously led to the downfall of Liz Truss, who became the shortest-serving prime minister in history.
Two critical missteps in Truss’s fiscal tactics contributed to her outcome: preventing institutions such as the OBR from assessing her £45 billion of unfunded tax cuts and displaying a blatant disregard for fiscal scrutiny during a significant global bond market downslide. The IMF advocated for the reversal of her entire mini-budget, while regulatory entities failed to address risks associated with pension funds leveraging liability-driven investment (LDI) strategies, which intensified the sell-off.
Seeking to engage bond traders for funding investments rather than tax cuts presents a far different scenario. “Bond markets can discern between various types of borrowing,” stated Tom Railton, director of Invest in Britain, a campaign group.
There are evident risks associated with significant increases in borrowing. Deutsche Bank estimates that the government’s issuance requirements could exceed £300 billion. Concurrently, the Bank of England is offloading bonds acquired during quantitative easing at an annual rate of £100 billion. With governments globally ramping up borrowing, investors have plenty of sovereign debt options.
Mohamed El-Erian, president of Queens’ College at the University of Cambridge and former Pimco chief executive, noted, “Markets recognize that investments enhancing productivity support long-term growth, bolster creditworthiness, and improve debt sustainability.” He emphasized the necessity for the government to communicate effectively and promptly how its budgetary strategies align with its growth objectives.
The government’s establishment of the Office for Value for Money represents an initial step towards bolstering its credibility with investors.
Dominic Caddick, an economist at the New Economics Foundation, stated that government bond yields are more responsive to investors’ predictions about the Bank of England’s fiscal policy reactions rather than the fiscal policy itself.
He added that if Reeves’s borrowing announcements fall short of market expectations, “interest rates could even decrease.”
One of the more anticipated pre-budget revelations has been Reeves’s plan to revamp the fiscal regulations.
The existing setup has been prone to manipulation by governments; chancellors can propose unrealistic spending cuts to depict a declining debt-to-GDP ratio between the fourth and fifth years of the OBR’s forecast. This tactic, employed by Hunt during the last budget, has been criticized by OBR chair Richard Hughes as a work of fiscal “fiction.”
A shift from PSND ex BoE to PSNFL would allow the chancellor immediate access to tens of billions of pounds by reducing the impact of the Bank of England’s bond sales on public finances and taking more financial assets into account alongside liabilities.
This modification would create a scenario where the so-called “golden rule,” which requires day-to-day government spending to be funded by tax revenues, becomes the primary constraint.
Ben Zaranko, a senior research economist at the Institute for Fiscal Studies, cautioned, “Focusing too heavily on a single measure can render it ineffective; it encourages attempts to bypass it.”
Zaranko recommended that fiscal rules should encompass a broader array of indicators, while others have proposed granting the OBR final authority in determining whether fiscal policies are credible.
Ben Caswell, a senior economist at the National Institute of Economic and Social Research, argued that excluding investment spending from fiscal targets would provide the government with “greater latitude to invest in long-term growth initiatives.”
Nonetheless, a recent House of Lords economic affairs committee report, titled “National Debt: It’s Time for Tough Decisions,” warned against this approach, as the classification of what constitutes government capital spending is ambiguous.
Historically, numerous chancellors have attempted to spur growth, primarily resorting to tax cuts, with only a brief uptick in capital spending under Boris Johnson’s administration. However, investment levels have consistently remained low, indicating that Reeves might have identified a crucial element required to propel the economy forward.
Smith from the Resolution Foundation succinctly encapsulated the imperative for increased investment: “There is no path to faster, sustainable growth that doesn’t involve elevating investment levels. The nation must cease relying on past gains and start investing in its future.”