Britain's fiscal plight stems from excessive caution

Will Torsten Bell and Minouche Shafik persuade the government to be bolder?

There is quite a bit of commentary at the moment of the British government’s economic predicament, with a tricky annual Budget coming up in the Autumn. The extreme version of this is the suggestion that a crisis is imminent, with Britain potentially be forced to borrow from the International Monetary Fund (IMF), perhaps even triggering a general election. This latter is being promoted by the nationalist right, including agitator Matt Goodwin, and picked up by organs such as The Daily Telegraph. I have not taken the trouble to explore this extreme narrative, largely because Mr Goodwin is disseminating it through video format in conversations with economist Liam Halligan. This is a format that I find irksome and time-consuming, and I avoid it, even when people like Paul Krugman use it. I also refuse to penetrate the Telegraph’s paywall. But it’s not hard to guess its general contours. The government has dug a hole for itself and jumped in. Can it get out?

A central narrative is emerging, around which the various versions, including extreme ones, branch off. This suggests that the government is in a deep fiscal mess. In last year’s Budget, the Chancellor of the Exchequer, Rachel Reeves, thought she had laid the foundations for a five year government. This featured a supposedly one-off raising of taxes (principally on businesses, and especially through employer’s National Insurance contributions), allowing a modest increase in public spending, in the framework of a falling budget deficit and reductions in government debt - at least measured as a ratio to national income. The latter “fiscal rules”, monitored by the semi-independent Office for Budget Responsibility (OBR), were central to maintaining the confidence of financial markets, and so keeping borrowing costs low. This was presented as a contrast the reckless polices of Liz Truss and Kwazi Kwateng, which caused their rapid defenestration in 2022 - when mortgage rates shot up after their so-called “Mini-Budget”. But the margin for error on these plans was small, and things started to go wrong in the Spring - in particular economic growth proved disappointing. In order to rectify this, the government decided to make disability benefits more restrictive. But this proved too much for the parliament Labour Party. Furthermore the government felt it had to partially reverse the withdrawal of a winter fuel benefit for old-age pensioners. This has created a budget gap that can only be filled by more taxes or spending cuts in the Budget. It gets worse: borrowing costs have been rising, partly because inflation is obstinately staying above the 2% target.

The government has made no real effort to challenge this narrative, but instead they have been flying kites as to various potential tax increases. These include property taxes, inheritance taxes, and taxes on rental income. This has generated the sort of scare stories that readers of The Daily Telegraph delight in. Ms Reeves seems to be caught in a trap of her own construction. Something has to give. My hope is that what gives is the government’s excessive caution and short-term focus. It helps to try and understand the economic fundamentals.

All commentators on the current situation, from the economically illiterate to the highly respected Institute of Fiscal Studies (IFS), are explaining government economics as if it was a household budget. You have income, expenditure and borrowing - and you have to manage this sustainably so as not to get into too much debt. Professional economists know that this is an example of the Fallacy of Composition - the fallacy that an aggregate economy behaves in the same way as its component parts do. But it is much easier to communicate with the public on this basis, so that’s what they do because they think it leads to the same place as a more sophisticated analysis. It usually does - but it is always worth pulling it apart from time to time.

Government fiscal policy is aimed at two main things: managing aggregate demand and financing the public debt. In the first of these the idea is to maintain sufficient demand to keep the economy in full employment, but not so much that it causes inflation. The idea that governments should do this is often referred to as “Keynesianism”. Much is heard about the need for economic stimulus when unemployment is high; people are quieter when there is healthy employment, or when inflation is high. Things are muddled a bit by more recent economic conventional wisdom - “Neo-Keynesianism” - which holds that the central bank should primarily be in charge of managing inflation through interest rate and other policies. But if a government does not want interest rates to rise (for example because of its effect on mortgage rates) then it should be careful about an over stimulative economic policy.

Another thing should be pointed out in this context. Fiscal policy here depends on whether any changes - public spending or tax changes - affect paying people to do things, or whether they are about shuffling passive wealth from one place to another. The latter aren’t important here. They include the interest the government pays on its debt, taxes on rich people and capital transactions, inheritance and wealth taxes, overseas aid and various budgetary manoeuvres involving the central bank. This is where much of the current political debate is, however. Public spending on benefits, though, and taxes on what the government calls “working people” (the trinity of income tax, National Insurance and VAT) are extremely important - as is spending on public sector jobs. Trying to balance a gap in demand-affecting taxes and spending with manoeuvres in the shuffling of wealth runs the risk of causing unemployment or inflation.

That is what almost everybody seems to be suggesting. Does it matter? That depends on how close the country is is to full employment and triggering inflation. The government’s reversals on benefits are not good news here, Bute not that the worries about extra interest costs aren’t relevant. Inflation, as normally measured through rising consumer price indices, is running at about 3%. Pay seems to be increasing at an even higher rate. That suggests the risk level is high. But the Bank of England is not increasing interest rates, and even modestly cutting them. This institution cares about the issue deeply, and examines the available data in depth. So perhaps higher inflation is just a temporary blip and the government can afford to run its fiscal policy fairly hot. But if this turns out not to be the case, the government must brace itself for increasing one of the holy trinity of taxes, cutting spending or allowing interest rates to increase.

All this seems to suggest that the second aim of fiscal policy, managing the national debt, is currently more salient. The overall level of debt, at about 100% of GDP, is quite high by recent historical standards after all. But there is a big difference between the government as a borrower and an ordinary household. The country can create money to pay the debt (“print money” as many misleadingly call it). The easiest way of doing this is getting the Bank of England to buy government debt in a process known as “Quantitive Easing” (QE). But the Bank will only do this under its current mandate if it felt inflation was not a risk - and preferably if its interest rates were very low. In fact it is quietly doing the opposite: selling off its huge holding of government securities acquired in early episodes of QE. This is an interesting area of public policy where, again, even experts often get muddled - but I think we can rule it out as an option for the government now.

One particular problem the UK has, and that some other countries with high levels of national debt do not (I’m thinking of Japan), is a significant and persistent level of current account deficit. The country imports quite a bit more goods and services than it exports. This must be matched by foreign capital coming into the country. This can take the form of business or property investment; or it can take the form of foreigners buying some of that government debt. This is a complex process that is resolved through open financial markets. Many countries try to manage this through capital controls (for example China) but this is much harder to do if your current account is in deficit: you can’t force foreigners to invest. For this and other reasons, interfering with the operation of international capital flows is not an option for Britain. This leaves the country highly dependent of financial markets. Commentators often anthropomorphise these markets, offering behavioural explanations of their movements, long before any real evidence of what caused them emerges. In fact markets are a complex interaction of a very diverse range of sources of supply and demand. Alas this does not make things any easier for the government - and it is critical for Treasury officials to gain an understanding of the stress points. Dismissal of such officials was one of the many mistakes of the Truss/Kwateng regime - which remains an object lesson in how to mishandle markets.

If managing the markets is a central part of the government’s job, there is a huge difference between managing government debt and managing demand. The latter is about hard numbers and facts - inflation, wages and employment in particular. The former is about narrative, combined with some dark arts about tactics and timing which don’t concern us at this point. The government has to paint a convincing longer-term picture about the trajectory of debt so that buyers will keep coming at reasonable rates. If this goes wrong you can get a sort of death spiral which leads either to an economic depression or to hyperinflation, and quite possibly both at once. The government’s fiscal rules and the role of the OBR is currently that narrative. But the measures required to sustain it without austerity or increases in the tax trinity - wealth taxes et al - could undermine it at the same time. Britain must keep attracting mobile foreign capital; if it doesn’t, the Pound will plummet and holding government debt will look a dodgy proposition.

And so the government is in a bind. The best short-term way out would be to increase income tax to claw back the losses to revenue made the last Conservative government from its reckless cuts to employee National Insurance. But the government considers this to be politically suicidal - and they may well be right. When it took power last year, the labour government’s watchword was caution; it sought mere tweaks to public policy to bring the country back to normal from years of Tory recklessness. They failed to grasp how difficult the country’s situation had become - though the evidence was plentiful. They are paying the price.

But I think there is a way out: to change the narrative presented to financial markets, and, just as importantly, to the British public, to allow a temporary breach of the fiscal rules. That narrative should be one of serious reforms to the economic infrastructure that will cost a bit more in the short term but will enable the country to better manage its debt longer term. There is a third aspect to fiscal policy: that is making the economy more efficient through changes to tax policy. This was central to the Thatcher governments in the 1980s under Chancellors Sir Geoffrey Howe and Nigel Lawson - who undertook a rebalancing of taxes to create a much more economically efficient framework. Both Chancellors carried out radical changes: Howe nearly doubled VAT in his first Budget alongside cutting income tax rates; Lawson took the top rate of income tax down from 60% to 40%, and radically redesigned Corporation Tax. This vision has gradually undone by every government since, as they tinkered with this and that, undermining the overall coherence of the tax regime.

Property taxes is one area that is ripe for reform. The current mix of stamp duty, capital gains tax and council tax leads to the inefficient use of land and housing stock. There are many ways that it could be made more efficient, by, for example, creating a land value tax to replace council tax and reduce stamp duty. But conventional political wisdom has it that changing the system is politically toxic - the same warnings given to Howe and Lawson in their day. There are rumours that the government is considering property tax reform. The assumption is that it will simply be a short-term fiscal raid to help balance next year’s budget without making the system any better - like the “reform” of disability benefits that the government attempted earlier this year. But it could be something much more interesting, and braver.

The government could back up its tax reform plans, and breach of fiscal rules in the short term, by the suggestion that it will increase income taxes in the next parliament if debt is not falling. This would directly challenge the nonsensical fiscal policies of Reform UK and the Conservatives and help take public opinion into more realistic territory. That would be equally brave.

The government is already spectacularly unpopular. And yet this has been earned by the government not being bold enough, rather than being too brave. In order to build a convincing narrative around reform, the government must show that it is prepared to take on difficult things. And if it’s going to be unpopular, it is better to make this for being brave than cowardly.

One hopeful straw in the wind is that Ms Reeves has promoted junior minister Torsten Bell to help her shape the budget. Mr Bell is an economist who is surely well aware of the need to reform Britain’s tax system. He is also acutely conscious of the need to battle inequality, having been Chief Executive of the Resolution Foundation. When I have heard him on the radio he has talked sense. Other changes to Mr Starmer’s own office are also encouraging: he has appointed Baroness Minouche Shafik, even more qualified than Mr Bell, as his economic adviser. Perhaps Mr Bell and Baroness Shafik can persuade Ms Reeves and Mr Starmer to be bolder, and present a convincing narrative of economic management and reform to the country and to financial markets. They have little to lose.