At Prime Minister’s Questions this afternoon, Rishi Sunak took a technical turn. Why is Rachel Reeves considering changing the fiscal rules, he asked the Prime Minister, when just last year she said doing so would be ‘tantamount to fiddling the figures.’ No clear answer followed.
The wisdom during the general election was that borrowing more money – to finance Labour or Tory spending promises – was simply not an option. No one dared to propose anything resembling Liz Truss’s mini-budget saga, which saw her attempt to borrow £100 billion to limit energy price rises for consumers.
Instead, the parties said they would make good on their spending promises by going for growth: a vital component to make the public finances sustainable, but also only as good as the supply-side reforms that back up the pledge.
It also was understood that Labour would opt for tax hikes – though most of those details were going to be kept deliberately vague until the Budget. Borrowing was out, growth was in. Tax hikes were the main debate – and major economic distinction – between the two main parties.
That wisdom, it seems, has gone out the window. As Labour is struggling to implement the relatively small tax hikes it announced during the campaign, it is now pivoting towards what was, just three months ago, totally unthinkable: more borrowing.
There has been speculation for several months that Rachel Reeves might make some changes to the current fiscal rules, which Labour had pledged to keep in their manifesto. However, it looks increasingly likely the Chancellor will update the rules to give herself more flexibility for capital spending. The IPPR think tank has released a report encouraging the Chancellor to make a change to the rules – which it says could release an additional £57 billion to spend on infrastructure and green energy investment.
But what might seem like a technical change could have vast implications: for the public finances, the trajectory of the national debt, and for Britain’s reputation with the international markets. Reeves must play a cautious game leading up to the Budget, to keep the markets onside. Already, it’s looking shaky.
The mini-Budget has not been forgotten. It was two years ago to the month that gilt yields were spiralling, Chancellor Kwasi Kwarteng lost his job and practically the whole Truss programme had to be undone by Jeremy Hunt. Since then, interest rates have hit a 16-year high. Debt servicing payments are now costing the UK double its defence budget.
It’s no surprise then, that markets are paying attention and responding to Reeves’s plans to loosen the fiscal rules. The ten-year gilt yield has been steadily climbing since the idea was first floated, reaching 4.2 per cent yesterday. This puts the UK at its biggest percentage point gap with Germany since August last year.
One problem for Reeves is that the current fiscal rules are considered to be very loose already. Introduced by Jeremy Hunt, they state that public sector net debt has to fall as a percentage of GDP on a five-year, rolling forecast. This essentially allows a Chancellor to get away with spending more in the short-term, on the condition they promise to stop spending down the road. Because the rule exists on a rolling term, a Chancellor can push the deadline for austerity back every year, and never have to make good on the cuts. It works, so long as the markets go along with it.
For Hunt and Rishi Sunak, the markets did. Call it confidence – call it vibes – but the pair gave the impression of fiscal competence. That impression was no doubt boosted by the 49-day Truss premiership that came before them. Still, it’s rather remarkable they got away with such a loose rule – which was a gift to the Labour party when it came to power. Now though, talk of loosening the rule further has drawn even more attention to the current set-up, which does not remotely guarantee fiscal prudence.
This doesn’t mean changes to the fiscal rules necessarily have to go the way of the mini-Budget. One big difference between the lead-up to the Truss growth plan and Labour’s first Budget is that the Treasury has been floating the plans in advance, giving the markets time to adjust and respond.
There are some positive noises about the Chancellor loosening the rules, including from pension investors in the Financial Times today, which Reeves will be delighted to read. Even if gilt yields continue to rise, the risk of a sudden spike after the Budget has been somewhat lessened.
We are also in a different phase of the rates cycle. Truss and Kwarteng decided to ask the markets for tens of billions of pounds just as interest rates were rising worldwide, leading to a faster surge in borrowing costs (specifically mortgage rates) than perhaps was necessary.
Two years on, the Bank of England is slowly and steadily reducing the base rate. While it appears Andrew Bailey (one again) got ahead of himself last week when he suggested more ‘aggressive’ cuts to come, the Bank has clearly indicated that more rate cuts are to be expected, giving Reeves a little more flexibility than Hunt had before her. And as economist Julian Jessop pointed out today, there are more subtle ways for Reeves to change the borrowing rules which would still unlock tens of billions for her. It doesn’t have to be as extreme as the staggering £50 billion-plus figure that is currently doing the rounds.
Still, there is not a huge amount of flexibility here. The markets will still need to be convinced that the money Reeves wants to spend on capital projects is money well spent (Whitehall doesn’t have the best track record for this, most recently evidenced by the HS2 fiasco). And the Chancellor will still have to find the cash to increase spending on public sector pay, for example, to make good on her other fiscal rule (that day-to-day spending is funded with revenue).
No doubt these dilemmas will be presented as ‘tough choices’. But borrowing is arguably the ‘easy’ option for politicians – or at least it used to be, when interest rates were on the floor and the assumption was that they would stay ‘low for long’. That is no longer the case, and hasn’t been for some time. That borrowing is back on the agenda shows just how difficult the other two policy levers – tax rises and growth reforms — are to pull for politicians.