The 3Rs: Reeves, Revenues and Resentment

I have said it many times before, but it is worth repeating that the on-the-day take of the UK Budget often misses much of the nuance. This is hardly surprising: we are bombarded with a huge amount of material which takes time to digest, and only once the dust has settled can we give a sober assessment, free from the imperative to say something quickly. But perhaps the most important takeaway is that we – and by we, I mean the electorate as a whole, but particularly politicians and the media – should stop treating a serious area of economic policy as if it were a piece of theatre. Fiscal policy has important implications, both at a microeconomic and macroeconomic level: The decisions taken on Budget day impact on household finances but also affect the nation’s creditworthiness. One might be forgiven for forgetting some of these bigger issues given the faux outrage generated by political opponents and the reaction in parts of the media (this is not a party political point: it is true irrespective of the party in office).

Communication breakdown

As for the framing of the Budget, shambles would be a polite description. Communication ahead of the Budget was characterised by the flotation of various fiscal ideas, as the government released a number of trial balloons, with the Chancellor Rachel Reeves hinting on 4 November that a manifesto-busting hike in income tax rates was on the cards. Just days later, however, the government rolled back on this policy. As the spin doctors got to work to explain the apparent U-turn, we were told that the official forecasts were likely to show a smaller black hole in the fiscal accounts than previously thought and that a rise in income tax rates was unnecessary. Instead a “smorgasbord” of smaller tax increases would be sufficient to ensure that the government could meet its fiscal rules. 

But on 28 November,  two days after the Budget, the narrative changed to suggest that in fact the OBR had informed the Chancellor as early as 31 October that she could still balance the current budget on a five year horizon, even without major tax hikes. Admittedly the margin was too small for comfort and some fiscal adjustment was still necessary, but it appeared to be a far less dramatic problem than we were led to believe.

Not too long ago, the pre-Budget period was characterised by ‘purdah’, with public officials prevented from making any comment on its content on pain of sanction. Once upon a time, monetary policy also used to be conducted in secret in the belief that surprising the market was the most effective means of policy control. The economic literature has since come to the conclusion that clarity and predictability are the corner stones of sound monetary policy. But this is not what we got in the four weeks prior to the Budget, which was characterised by mixed messaging and confusion, none of which helped to shore up fiscal credibility and served only to heighten market volatility. Silence can indeed be golden.

The shambolic communication extended to Budget day itself when the OBR’s main publication was released tothe public before the Chancellor had a chance to inform parliament of her fiscal plans. It is not for me to say whether that was a breach of the law but it was certainly a breach of protocol. Nor do I have any strong views as to what, if any, sanctions should be imposed. But Chris Giles, writing in the FT, noted that: “The OBR’s error is worse than other Budget leaks because the fiscal watchdog exists solely to improve the process and has failed in its main job. The disaster exposes the OBR to future political questions and undermines the case for independent economic institutions … If the OBR cannot organise its document handling, how can we trust it to get the judgment on productivity or the tax richness of GDP forecasts right?” 

Giles did not explicitly call for the OBR’s Chair, Richard Hughes, to be sacked but he certainly hinted that he should be left alone in the study with a pearl-handled revolver. This seems a little harsh given all the anonymous leaks to which we have been subject over the last month.

Was the economics any better?

The answer to that question depends on what we think is the primary objective of the Budget. In my view, those who believe the Chancellor did not do enough to boost growth are missing the point. In the words of the Parliament website, the Budget “is a statement … on the nation’s finances and the Government’s proposals for changes to taxation.” Essentially, the Chancellor has two instruments at her disposal – taxation and spending – to control two quantities (revenues and outlays). Using the tax instrument to target both revenues and growth is asking for trouble. Indeed, the Tinbergen rule states that there must be at least as many independent policy instruments as there are independent policy objectives to achieve them efficiently.

Focusing on the more narrow fiscal questions, however, a lot of awkward questions remain to be answered. Starting with the fiscal rules, the good news is that the OBR’s forecasts suggest they will be met. The Chancellor has a bigger buffer (£22bn) to accommodate any narrowing of the current surplus by 2029-30 (this was a mere £9.9bn in March). However, the OBR only assigns a 59% probability to the chance this will be achieved: While this is the highest in the post-Covid era, it is far from a ringing endorsement (chart above). 

The supplementary target for public sector net financial liabilities (PSNFL) to be falling in 2029-30 is also met in the central forecast, but the probability assigned to this target is just 52%. Indeed, a debt-to-GDP ratio currently close to 90% and set to go higher means that debt servicing costs are highly vulnerable to swings in bond yields. Around 9% of revenues are currently used merely to pay debt interest: At a time when there are so many other competing demands on public finances, this makes debt reduction an imperative (chart below).

A lot has been said and written about the individual fiscal measures and there is little point in rehashing it here (see the IFS analysis for more detailed insight). But a few things are noteworthy: Rachel Reeves did say a year ago that she would not be coming back for more tax revenue following the rise in employer NICs. But she did, and the largest single measure was the extension of a freeze on income tax thresholds from 2028-29 which is set to generate roughly half of the additional tax revenue predicted by 2030-31. Although Reeves did not raise marginal income tax rates, this freeze implies an increase in average income tax rates as earners are pulled into higher tax bands thanks to inflation, hurting the lower paid. There is also a political dimension: A general election must be held no later than summer 2029. In the absence of any recovery in popularity, the government will be going into an election campaign on a platform of higher effective taxes. It is unlikely to be a vote winner and it is a policy which may not survive contact with political reality.

Trying to put it in context

As my colleagues at NIESR noted in the wake of the Budget, it “locks in a high-tax, high-debt steady state in a world of low productivity growth and higher interest rates. Even the historically large tax share of GDP now planned is only just enough to stabilise – not reduce – a debt ratio stuck around 100 per cent of GDP for the foreseeable future … there was a notable lack of economic vision beyond clearing fiscal hurdles. Reforms to the triple lock, council tax, and VAT were pushed into the background while the Chancellor focused – justifiably – on meeting the fiscal rules.”

In other words, the Chancellor – like most of her predecessors – continued to dance around the elephant in the room, goaded on by a rabid commentariat in thrall to the economics of the 1980s. Either voters have to accept that they will have to stump up for the public services they say they want, or they will have to find alternatives. Over the past 40 years, successive governments have told the electorate that consumers are best placed to spend their own money and that they want to put more money back into their pockets. 

This is a laudable objective, but what governments failed to point out is that a smaller state means that voters will have to pay more out of their own money for certain services. More money in voters pockets means less goes to the NHS so if consumers want the same quality of service, they will have to pay more for private health cover. Implicitly, Reeves did drop hints in this direction in her Budget speech. But it is an unpopular message and if a government with a 148 seat majority in parliament is unable or unwilling to make the case, we should not hold our breath that we will be able to have an adult conversation about fiscal trade-offs any time soon.

Taxing times

Following Chancellor Rachel Reeves’ speech on 4 November, it appears that the government is considering breaking one of its manifesto pledges not to raise taxes on working people. There is considerable speculation that the Chancellor will announce a rise in income taxes on 26 November for the first time in 50 years (neither the basic nor the higher rate have been raised since 1975). This is far from a certainty. Indeed, the government will be taking an almighty risk: An unpopular government lagging in the polls does not lightly break such a key election promise. But if it does happen, it is imperative that the government uses the revenue to improve public services in order to fend off the electoral rise of Reform UK. Failure to do so may harm Labour’s chances at the next general election.

Tax choices are political as well as economic decisions. In many ways the government created a rod for its own back prior to the 2024 election by pledging not to “increase National Insurance, the basic, higher, or additional rates of Income Tax, or VAT.” History suggests it is very unwise to make such commitments when economic circumstances can change very quickly (think the GFC, Covid or the impact of the Russia-Ukraine war on oil prices). The pledge was thus an unwise political choice that is set to be reversed. Any tax-raising decisions later this month thus have to be viewed through the lens of politics, as well as economics.

The economic choices are clear enough: Raise as much revenue as possible while inflicting the least amount of damage to economic growth. The political choices are more difficult to navigate: Where should the burden of tax increases fall without damaging political support? Politicians would like to shift the burden of tax onto businesses wherever possible – after all, they do not vote (although they may be substantial political donors). However, having raised payroll taxes in the form of higher employer National Insurance Contributions and hiked the minimum wage in April 2025, scope for asking businesses to bear even higher costs is limited. Raising minimum wages has contributed to higher inflation in recent months, and there is evidence to suggest the labour market is losing momentum.

While voters clearly do not relish the prospect of higher taxes, they are the ultimate consumers of public services and will be required to pay in some form. In any case, much of the deterioration in public finances over the last five years can be attributed to government support during the Covid crisis and the subsequent energy price spike. As I pointed out in March 2020: “A question which has been put to me by non-economists is who is going to pay for all this largesse. In truth, we are – maybe not immediately, but in the longer run … Under normal circumstances, bond yields would be expected to rise sharply in anticipation of big increases in national debt, which would in turn imply a rising proportion of tax revenue being used to service debt. Governments would thus be expected to respond with fiscal tightening.”

What options are available to the Chancellor?

The Chancellor has two problems: In the short-term, she needs to raise additional revenue, but in the longer-term the tax system needs an overhaul – a topic which I have touched upon on numerous occasions in the past (here, for example). But the political cycle being what it is, the Chancellor will have to act to plug holes in the public finances sooner rather than later. In the last fiscal year, almost 79% of central government revenues were derived from just four tax heads – incomes (31%), VAT (20%), social contributions (18%) and corporates (10%). As a matter of expediency, it is these four areas which are most likely to be raised in order to generate significant sums.

I am indebted to my colleague, Ed Cornforth, for running the numbers through NiGEM – NIESR’s global macro model – to assess the economic consequences of various tax hikes, with the results summarised in this policy paper. The results suggest that raising income taxes would be the least distortionary policy action in terms of its short- and longer term impact on inflation, unemployment, GDP and interest rates. Raising VAT is pretty much a non-starter given its regressive implications, not to mention its near-term impact on inflation. Increasing corporate taxes depresses the economy’s potential growth rate by reducing investment, which ultimately reduces productivity and real wages and leads to higher unemployment. It is thus easy to understand why Chancellor Reeves would be tempted to increase income taxes – it is the least worst of the short-term options.

It is unlikely that all of the fiscal shortfall will be covered by income taxes alone. My NIESR colleagues calculate that in order that the government achieve its goal of balancing the current budget by fiscal year 2029-30, while ensuring an adequate buffer against unforeseen shocks, a fiscal tightening of at least £50bn will be required. According to the HMRC’s Ready Reckoner, achieving this solely through income tax hikes would require an increase of almost 5 percentage points in the basic and higher rates of income tax (currently 20% and 40% respectively) which would seem to be a political non-starter. A more balanced package comprising a 1pp rise in income taxes, employee NICs and inheritance duties, together with increases in various duties, could raise around £20bn. In other words, we can get almost half way there by pulling on some of the more obvious levers but this would still leave us a long way short. It is notable that while the Resolution Foundation’s creative proposal to increase income taxes by 2pp while compensating with a 2pp cut in employee NICs may dilute much of the political anger, it would offset much of the fiscal effect, rendering it less useful.

Of course the other option open to the Chancellor is spending cuts. But having set out a Comprehensive Spending Review as recently as June, it is difficult to imagine that the Chancellor will want to rip up her carefully crafted spending plans (though some cuts at the margin may be a possibility).

More radical options for tax reform

Among the areas open to scrutiny is the taxation of pensions. Currently, employee pension contributions receive income tax relief at the highest marginal rate which means that higher-rate taxpayers receive 40% relief, whereas basic-rate taxpayers receive only 20%. It is often suggested that this creates a series of perverse incentives, whereby those who are already better off gain the greatest benefit, while lower earners receive comparatively little encouragement to save for retirement. Reforming pension tax relief – such as moving to a single flat rate of relief – has long been proposed as a way to improve fairness and potentially raise revenue. Indeed the IFS estimates that limiting relief to a flat rate of 20% would generate an additional £22bn by 2029-30.

However, the IFS also points out that it would be unfair to give relief at 20% but impose a marginal tax of 40% on those whose retirement income pushes them into the higher tax bracket. Instead, it suggests that around £6 billion per year could be raised by introducing NICs on employer pension contributions, which are currently exempt. An alternative would be to align the tax treatment of contributions and withdrawals (e.g. pension income is taxed at 20%), or introduce a tapered system that balances fairness with fiscal sustainability (e.g. tapering tax relief at rates between 20% and 30% depending on incomes).

But such measures would serve only to introduce additional complexity into an already complicated tax system. Prior to the 2024 general election I suggested that one thing the incoming government might consider was a Royal Commission on tax reform to assess the proposals made in the 2010 Mirrlees Review. The main conclusions of the Review were that the tax system should raise revenue efficiently, minimising distortions to work, saving and investment decisions by avoiding piecemeal changes that create inconsistencies. Currently, it is quite the opposite: as Martin Wolf pointed out in the Financial Times recently, “the tax system is a mess”. But it may still not be too late to implement a reform plan, perhaps in conjunction with the modest tax hikes set out above. Indeed, it might be possible to sell a need for temporary tax hikes which will be at least partially reversed when the suggestions from a Royal Commission are implemented (admittedly, that would be a tough sell).

Last word

This is not the place to go into a detailed review of some of the areas that are ripe for reform, but a coherent look at property and inheritance taxes are clearly required. Motoring taxes and carbon emissions taxes are other areas of the system where an overhaul is necessary; it has always seemed inconsistent that motoring fuel duties have been frozen since 2011 at a time when governments have expressed their commitment to net zero. As the IFS has noted, if fuel duties had been uprated in line with RPI inflation since 2011, it would have an additional £17.4bn of revenues to play with.

The bottom line is that the current fiscal model has run out of road and it is time to think more seriously about what voters want government to deliver and how we can pay for it. As I have noted many times previously, the tax cutting policy introduced in the 1980s was viable in a world where the old age dependency ratio was stable, but it has risen sharply over the last 15 years and will continue to do so for at least the next 25. This suggests that it is time to bite the bullet on fiscal policy and have the grown-up conversation between government and voters that has been postponed for too long.

The silly season: A numbers game

As August gives way to September and the media’s so-called “silly season” winds down, attention shifts to the return of football. With the new season having kicked off, and today’s transfer window now having closed, it can sometimes feel as though a different kind of silly season is only just beginning. Yet football is merely a reflection of our society with its passions, excesses and contradictions. The sport magnifies our tribal instincts, celebrates collective joy and exposes the widening gulf between ordinary fans and the vast sums of money that swirl around the game. It is also – as I have frequently noted – a great test bed for applying economic and statistical analysis.

Some economic reflections on this year’s big stories

While football can provoke great debate, it is just as likely to be treated with indifference by a large section of the population. But it is hard to ignore. Even the Financial Times is taking notice, with its fun online challenge (Can you run a Premier League football club?) and an article equating the decline of Manchester United with the fall of the Berlin Wall. I have long thought that the diminished prowess of the Red Devils speaks more to the industrial economics literature on why dominant firms decline. Empirical research conducted by Paul Geroski in the 1980s[1] challenged the conventional view that dominant firms do indeed decline. Paul is alas no longer with us, but he did develop a surprising affinity for football, and he would almost certainly conclude that Manchester United’s recent travails do not represent a permanent shift in the club’s fortunes.

To the sports journalist or the casual fan, the standoff between Alexander Isak and Newcastle United, in which the player’s refusal to train with the team as he tried – eventually successfully – to force a move to Liverpool, may seem like the petulant actions of a spoiled star. To the economist, they represent calculated moves in a high-stakes financial negotiation. Isak’s motivation is clear: moving to one of Europe’s top clubs will propel him into the footballing elite, generating more trophies and a higher income. A footballer’s career is short, and could be ended tomorrow by injury. It is thus rational for him to attempt to maximise his income.

What about the clubs? Newcastle are about to reap the benefit of Champions League revenues, and must weigh the immediate windfall of a record-breaking player sale against his value on the pitch, where his contribution could see the team progress further in the competition thus generating additional broadcast, matchday and win-related revenue. For their part, Liverpool must balance ambition with fiscal prudence. A blockbuster signing is no guarantee of success and the club must be careful that a fee in the region of £130 million does not undermine their carefully maintained financial model under the Premier League’s Profit and Sustainability rules (PSR).

Indeed, one of the features of the transfer window – the player trading period that closed today – is what it reveals about how modern football teams manage assets, revenue streams and strategic risk. The economics of football transfers are increasingly shaped not just by player ability but by contract dynamics. The Isak case is unusual because he had three years left on his contract. But when a player has only a year left on his deal, his transfer value typically falls sharply because the selling club risks losing him for free under the Bosman ruling. This shifts bargaining power towards the player and the buying club: the player can threaten to run down his contract, forcing a cut-price sale, while suitors know they can secure him on a free the following summer. As a result, clubs often face a strategic dilemma – cash in now at a reduced fee, or gamble on retaining the player’s services for another season and risk losing a valuable asset without compensation. In a financial landscape constrained by PSR regulations, these contractual time horizons are as important to balance sheets as the players’ performances on the pitch.

The real action is on the pitch

While much of the economics focuses on the finances, the action on the field lends itself to statistical analysis. Last autumn, I took a look at Premier League prospects for season 2024-25 on the basis of a Poisson simulation model[2]. How did I do? First the bad news: I gave Liverpool only an 8% chance of winning the title (they won comfortably). More positively, I tipped the five clubs who would win Champions League places; correctly predicted two of the three relegated teams and called 8 of the top 10 teams. I will leave it to the reader to judge whether that was an acceptable performance.

The method has a substantial academic pedigree[3] and last year’s performance was sufficiently robust that it is worth trying it again as a means to forecast outcomes for season 2025-26. As a reminder, the model simulates each game 1000 times and adjusts expected goals (λ) by adding a random number in the range [-1<n<1] in a bid to capture the element of luck inherent in any sporting contest. The results are shown in the table below.

Even before a ball was kicked, the model suggested that Liverpool were favourites to retain their title (57% probability, or evens favourites) with Arsenal, Manchester City and Newcastle making up the rest of the top 4. The unfortunate favourites for relegation are Burnley, Wolves and Sunderland (probabilities of 47.5%, 45% and 76% respectively). It is notable that the pre-season rankings generated by the model broadly accord with the bookmakers rankings. In the chart below, I use the bookies odds of achieving a top 4 finish as a proxy for team’s relative strength. In cases where the club is placed above the diagonal line, this represents cases where the bookies are more optimistic than the ranking predicted by the model (take comfort fans of Tottenham and Manchester United). Similarly for those clubs placed below the diagonal, the bookmakers are less optimistic (fans of Leeds, Brentford and Bournemouth take note). Given that last year’s results form the basis of the model’s expected goals parameter (λ), and the weight of money placed with the bookmakers is heavily influenced by last year’s performance, congruence in the results should not be a great surprise.

One of the weaknesses that I tried (unsuccessfully) to address is the momentum effect. If a team starts the season well (badly), does it represent a temporary deviation from the mean or does it represent a genuine improvement (deterioration) in performance relative to last season? In an attempt to address this problem, I experimented with a dynamic estimate of λ based on an exponentially weighted average of recent performance. In this approach, the starting value for λ is last season’s average although over time this plays a diminishing role. Early random match results feed back into the calculation of subsequent expected goals (λ), and each week these noisy current-season averages are blended with last season’s stats. This repeated averaging pulls temporary leads or deficits toward the league mean, reducing persistent differences between strong and weak teams. This feedback loop compressed variation across simulated seasons, causing title probabilities to bunch up, making the league appear artificially balanced compared with a static model where team strengths remain fixed. Perhaps with a bit more time I could develop a dynamic approach that improves on the current method, but for now the fixed λ approach appears to generate a better approximation to reality.

Last word

Applying statistical methods to football outcomes is both fascinating and practically valuable because it allows us to move beyond intuition and anecdote, quantifying the uncertainty inherent in each match and across an entire season. By modelling goals, team strengths and dynamic interactions, we can simulate outcomes that would be impossible to assess reliably by eye. This not only deepens our understanding of the game’s underlying patterns but also provides actionable insights for analysts, coaches and fans. It illustrates how a combination of mathematics, probability, and real-world data can illuminate the complex, dynamic and often unpredictable world of football. This approach is not limited to football: the same principles can be applied to virtually any competitive or stochastic system where outcomes depend on multiple interacting factors, from other sports to business forecasting, financial markets or epidemiology. In all these contexts, statistical modelling enables a deeper understanding of underlying patterns, informs decision-making and helps anticipate outcomes in complex and uncertain environments. Just don’t assume that my model is going to make you rich.

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[1] Geroski, P. A. and A. Jacquemin (1984) ‘Dominant firms and their alleged decline’, International Journal of Industrial Organization (2) 1, pp. 1-27

[2] The Poisson distribution – a probability distribution that describes discrete events – is commonly applied in football analytics to model and predict match outcomes because goals in a match can be thought of as rare, discrete events that occur independently over time. In this framework, each team is assumed to score goals at a constant average rate (λ), and the Poisson distribution gives the probability of scoring exactly 0, 1, 2, … goals in a match. The probability mass function for a variable following the Poisson distribution is defined as  where X is the number of goals a team scores in a match and k is  a specific outcome (a non-negative integer: 0, 1, 2, …). For example, k=2 means “the team scores exactly 2 goals.

[3] Dixon, M. J. and S. G. Coles (1997) ‘Modelling Association Football Scores and Inefficiencies in the Football Betting Market’ Journal of the Royal Statistical Society Series C: Applied Statistics, Volume 46, Issue 2, 265–280

Rationality meets reality

 The rational expectations (RE) revolution which swept through macroeconomics in the 1970s and 1980s has changed the way we think about many aspects of macro. As theories go, it is coherent and persuasive and has allowed us to think differently about many aspects of economics and finance. But there have been rumblings recently from respected professionals in the field expressing doubts about its usefulness. As one who has never fully bought into the idea that this is actually how people form expectations, I am obviously prone to confirmation bias, but clearly I am not the only one who has reservations about one of the key underpinnings of modern macroeconomics.

What are rational expectations?

In very simple terms, RE assumes that economic agents make the best use of all currently available information to make predictions about future events in a logically consistent manner. The upshot is that individuals do not make systematic forecast errors (although they can make random errors). This appears uncontroversial at first glance but it has profound consequences for policymakers. Prior to the work of Robert Lucas in the 1970s, it was assumed that a paradigm used to assess the outcome of a policy change would either remain unchanged in future, or would change only slowly as expectations adapted to new evidence. But Lucas pointed out that as economic agents recognise and internalise the way policy affects the economy, they will change their expectations formation process. As a result, the old paradigm is no longer valid. Applying the same policy options in future would result in different outcomes because agents would anticipate what was likely to happen and act accordingly.

A simple example is the  Phillips curve, which was based on the idea that there is a stable and exploitable inverse trade-off between inflation and unemployment. In this static world, a policymaker wishing to reduce unemployment would be prepared to allow inflation to rise. But in a world where expectations are formed rationally, they can only get away with that once.  Next time round workers push for higher wage claims to offset the erosion of real wages, with the result that employment falls (unemployment rises). As it happened this was pretty much what happened in the 1970s as the inverse relationship between the two broke down.

Lucas led the intellectual charge of New Classical economics which usurped the dominant Keynesian paradigm, and challenged the efficacy of discretionary macroeconomic policies by arguing that if individuals can foresee the consequences of policy changes, attempts to manipulate the economy through fiscal or monetary policy become less effective. The New Keynesian response was to synthesise Keynesian principles with insights from the New Classical revolution. Crucially, however, they did not reject the RE hypothesis.

Finance, too, has been captured by the RE revolution. RE are a key component of the Efficient Markets Hypothesis, according to which asset prices reflect all available information, and market participants form rational expectations about future events. In an efficient market, it is assumed that investors cannot consistently achieve abnormal returns by exploiting past information because prices already incorporate all relevant data. Furthermore, the Capital Asset Pricing Model (CAPM) assumes that investors form homogeneous and internally consistent expectations about returns, which is related to the rational expectations idea that agents' forecasts are consistent with the model they use.

Are expectations formed rationally?

Rational expectations are, to use the jargon, ‘model consistent’. In other words the average predictions across all economic agents match the predictions of an economic model which captures the true structure of the economy. Obviously, we are not solving complex models of the economy to derive views about the future. Instead, we rely on heuristic rules of thumb, public forecasts, market signals or simplified mental models. If these rules generate outcomes in line with how the economy actually works, we can still proceed on the basis that agents form rational expectations. But it is questionable whether such rules actually work, particularly at times of elevated uncertainty such as we are experiencing today. Given the raised prospect of extreme outcomes in the wake of Donald Trump’s election, we have even less certainty about what the world might look like in future. Due to this lack of information, agents can be excused for simply extrapolating forward based on past performance on the basis that this represented “normality” and that risks are evenly distributed around this outcome. It might be a rational way of looking at the world, but now expectations are being formed adaptively rather than in a model-consistent way.

What does the evidence tell us?

Nowhere are RE more central than in financial markets, where asset prices are typically assumed to reflect the rationally expected present value of future cash flows. In an important 1981 paper, Robert Shiller examined this idea by testing whether fluctuations in stock prices could be explained by changes in expectations of future dividends. According to the standard RE-based present value model, most of the variability in prices should come from new information that affects expected future dividends. However, Shiller found that actual stock prices were far more volatile than the relatively stable stream of realised dividends would justify. This result, often described as the “excess volatility puzzle,” called into question whether prices are set purely on the basis of rational expectations, or whether they are also influenced by factors such as changing risk premia, investor sentiment, or other non-fundamental forces.

In an attempt to update the Shiller methodology, I computed the ex post “fair value” of the S&P (in real terms) by discounting actual realised dividends over a five-year horizon, assuming perfect foresight of future payouts. As the dataset extends only to June 2025, the perfect foresight calculation is only feasible up to June 2020; for subsequent periods, I extrapolated using the trailing 12-month average dividend to maintain a continuous valuation series. While this is not exactly comparable, it is an approach often used in the academic literature. The results suggest that around the time of the dot com bubble in the late-1990s, and again around the time of the Lehman’s bust, equities were overvalued relative to fundamentally justified levels. However, these periods pale in comparison to the post-2020 period (methodological differences notwithstanding), suggesting that equities may be experiencing a period of irrational exuberance.

Providing statistical evidence for the existence (or absence) of RE is challenging. One approach is to compare the fundamentally justified price – defined above as the discounted value of future earnings – with the actual observed price. If RE hold, all available information should already be reflected in the price, implying that the difference between the two should not be systematically related to any other variable. Consequently, regressing this difference on another metric should yield a coefficient that is not statistically different from zero (see below).

However, the results suggest that a regression of the difference on observable variables such as the P/E ratio or dividend yield do indeed generate coefficients which are statistically significantly different from zero. The charts (below) plot the forecast error – defined as the difference between the actual return and the expected return – against the observed P/E ratio and dividend yield. Under the RE hypothesis, forecast errors should be purely random: they should not be systematically related to any information known in advance. This should appear as a scatter of points randomly distributed around zero, with the fitted regression line essentially flat. But the plots show a statistically significant upward slope, suggesting that forecast errors are systematically related to both the P/E ratio and dividend yield, which imply that investors could, in principle, have used these variables to improve their forecasts. This provides some evidence against RE, as it implies that prices do not fully incorporate available information at any given time.

You don’t just have to take my word for it. Cliff Asness, one of the most astute and intellectually rigorous portfolio managers out there, wrote an excellent paper in 2024 arguing that markets have become far less efficient since the early 1990s. Asness offers three reasons why markets are now less efficient compared with the pre-1990 period: (i) the rise of indexing has made stock prices more inelastic with respect to new information; (ii) an extended period of low interest rates has distorted investors ability to respond appropriately to changed information and (iii) the rise of social media has amplified trend following and momentum strategies at the expense of rational information processing.

One worrying thought is that if markets, with their access to huge amounts of data, are not processing information in a manner consistent with RE, what is the likelihood that households are doing it? This matters because RE are absolutely central to modern DSGE (Dynamic Stochastic General Equilibrium) models in which agents (households, firms, policymakers) are assumed to form expectations about the future that are model-consistent. If expectations are not formed rationally, forecasts based on such models may be potentially biased, and policy outcomes may be less effective.

Final thoughts

Looking at market movements in recent months, perhaps we can be forgiven for thinking that the past is the only guide we have to future performance. But such reliance on past trends carries its own risks. Adaptive expectations, by definition, anchor forecasts to recent experience, making them slow to incorporate new structural shifts or unprecedented shocks. In the current environment of heightened uncertainty, characterised by a global political realignment and the disruptive potential of technological change, such inertia may lead to systematic forecast errors. Instead of anticipating turning points, markets and policymakers risk being repeatedly surprised by outcomes that fall outside the narrow band of recent history.

Moreover, if everyone leans too heavily on the same backward-looking heuristics, market dynamics themselves can amplify volatility. Herding behaviour may set in, reinforcing bubbles or deepening downturns as agents all update beliefs in the same direction, as Asness implies. In this sense, the process of expectations formation becomes not merely a passive reflection of past data, but an active force that shapes the trajectory of the economy.

Unfortunately, it is extremely difficult to capture the complexity of the expectations formation process, while those which rely solely on historical patterns risk missing the disruptive events that define each economic cycle. Whether expectations can ever be fully rational in the strict sense remains debatable – but recognising the limitations of both model-based and adaptive approaches is a step toward better decision-making in an uncertain world.

 

A rough start with worse to come

Keir Starmer’s Labour government took office a year ago following an overwhelming election victory that consigned an unpopular Conservative government to history. I did, however, warn that Labour’s victory owed less to its own popularity and more to the electorate’s desire for change. As I noted at the time: “This makes it all the more imperative that Starmer’s government gets the big things right quickly. Making voters lives better is the one thing that will raise the chances of a second term in office – a second term that will undoubtedly be required to properly fix many of the things in the economy that require improvement.”

Fiscal challenges and policy U-turns

Measured against this yardstick, the government is failing to meet its objectives and there is common agreement that it does not have a clearly defined philosophy. Economic policy has largely been focused on tackling the UK’s mounting fiscal burden. The Chancellor, Rachel Reeves, claimed in summer 2024 that the situation was worse than Labour imagined before taking office, though as the Institute for Government has noted: “the truth is that most of the tough fiscal choices that this government faced were well known before the election – politicians from both main parties simply chose to ignore them.” Reeves claimed that unfunded spending commitments made by the previous Conservative government resulted in a £22bn “black hole” in public finances (around 0.8% of GDP). While it is true that a Treasury audit pointed to a departmental overspend in fiscal year 2024-25 of £21.9bn, almost half of this arose from the current government’s discretionary decision to accept recommendations for public sector pay awards which were higher than those factored in by the Tories. Nor has the £22bn figure been endorsed by the OBR, which suggested that the previous government’s unannounced policy commitments were worth around £9.5bn.

Hemmed in by its manifesto commitment not to raise taxes on “working people”, the Chancellor was forced to find some measures to show the government’s commitment to fiscal rectitude. But the proposals put forward by Reeves have been poorly presented, with the result that the government has backtracked on policy announcements in the face of opposition. A case in point was the plan to limit the Winter Fuel Allowance to only the poorest pensioners. The payment was originally introduced in 1997 as a universal benefit but the incoming Labour government surprisingly announced in 2024 that it would be converted to a means-tested benefit. This generated a huge wave of criticism and was cited as one of the reasons why Labour performed so poorly in the May local elections and prompted a policy U-turn shortly afterwards. 

For all the political capital which was squandered by the policy, it was only expected to save £1.4bn of fiscal outlays, and the policy reversal, which raises the income threshold for the benefit, will now only save around £0.45bn – a trivial amount in UK fiscal terms (see chart above). Indeed, fiscal data for the first ten months of Labour’s tenure show that borrowing has risen by £33bn (around 1.1% of GDP) versus the corresponding period a year earlier.

Similarly, the government was forced this week to significantly water down its planned reform of the welfare system in the face of fierce opposition from backbench Labour MPs. Here, too, the fiscal savings resulting from tightening access to welfare payments are relatively small in the grand scheme of things, with an estimated saving of £5.5bn by fiscal 2029-30. As was the case with the Winter Fuel Allowance, a huge amount of political capital was risked to achieve a small monetary saving. This has raised questions about the government’s political acumen and has increasingly called the prime minister’s authority into question. While this is the normal response of a commentariat which likes nothing better than to poke holes in the shortcomings of the government of the day, it is increasingly clear that Starmer’s administration has failed to regenerate the feelgood factor. To the extent that the government is going to need a second term to address the deep-seated economic problems facing the economy, the fact that Labour now trails Nigel Farage’s Reform UK party in the polls should act as an urgent wakeup call (see chart below).

Hard to see how taxes cannot rise

Matters might well get worse before they get better. Indeed, there is increasing speculation that the government will be forced to raise taxes in the autumn, despite the manifesto commitment not to do so. The howls of protest from opposition political parties, and perhaps even from backbench Labour MPs, will be predictably loud, but in truth the government is out of fiscal options and has very little headroom to ensure that its fiscal rules can be met over the course of this parliament. Public services are stretched and the electorate has noticed. The NHS remains under huge pressure, and although there has been a small decline in waiting lists for treatment in the past 12 months, public dissatisfaction with the NHS continues to hit new highs (see chart below). Nor has the abolition of NHS England gone down well with medical professionals. The prime minister sold it as a way of increasing efficiency by reducing the degree of centralisation: Insiders see it as a way to cut NHS jobs. Equally importantly, the criminal justice system is operating with no spare capacity, to the point at which the government even experimented with the early release of prisoners to alleviate the strain – a policy which is unpopular with the public.

And then there is defence spending. The government plans to raise it to 2.5% of GDP by 2027 (2024: 2.3%) and has ambitions to increase it to 3% in the next parliament. NATO is seeking agreement from members to raise it to 5% by 2035, comprised of 3.5% under the current core definition with a supplementary 1.5% allocated to critical infrastructure protection. The uplift in 2027 will be financed by a reduction in the overseas aid budget but it is hard to conceive that any further increase can be achieved without raising taxes. A near-doubling of defence spending, to 5% of GDP, would take it to its highest level since the mid-1950s (see chart below). Faced with an ageing population which will stretch the NHS budget, and a sluggish productivity performance which continues to hold back growth, this government – and the next one – will have to make some very hard choices about how to spend their increasingly limited fiscal resources.

The government needs to improve its performance – and fast

Whether Starmer will be the prime minister beyond the next election remains to be seen. He has defied the doubters before, and is not someone who should be underestimated, but his personal popularity ratings are not high. In the wake of the recent policy U-turns, his net approval rating has dropped to -43% with mounting concern that he has responded to the electoral tactics of Reform UK rather than set the agenda on his terms. Starmer’s government has endured a rocky start and needs to outline an agenda which voters can buy into. Failure to do so in the second year of this government will merely raise the risk that Nigel Farage and his band of upstarts could come close to getting their hands on the levers of power in 2029.

As was the case with Labour’s big win in 2024, voters do not have to buy into Reform UK’s policies to reward them at the ballot box. They just need to believe that the status quo is failing, and that it is time to try something different. It may be four years until the next election, and the electorate may eventually forgive Labour for their rocky start, but Starmer and his team cannot afford another year like the last one if they are to win a second term.

The games Donald plays

 

By now, anybody who is anybody – and plenty who aren’t – has had their say on the Trump tariffs and their possible implications. Much ink has been spilled documenting the twists and turns of the Trump Administration’s actions and the subsequent market movements. If there is one lesson to be learned from recent weeks, it is not to overreact to latest events because likely as not, there will be a rollback which renders the previous position invalid. That is not to say markets are wrong to sell off/rally as Trump’s whims dictate – after all, investors have to take a position based on available information because each signal from the White House alters the landscape of risks, costs and growth expectations. But it is no way to run an economy.

More than a game

One way to think of Trump’s strategy is through the prism of game theory, and there are some elements which echo the main findings of Thomas Schelling’s classic 1960 book, The Strategy of Conflict – a seminal work in game theory and strategic decision-making, particularly in the context of conflict, negotiation, and deterrence. One of the key takeaways of Schelling’s work is that conflicts are not merely power plays that pit one side against another, but are instead contests that highlight strategic interdependence – in other words, the actions of one player have an effect on the strategy of the opponent.

Schelling also highlighted the role of brinkmanship in which pushing one party further outside their comfort zone forces them to change their own strategy. This is very clearly the case in the context of the US-China trade row which threatens to inflict significant economic damage unless cooler heads soon prevail. China responded to the 145% levy on exports to the US with a tariff of 125% on US imports, highlighting the impact of brinkmanship. But the strategic interdependence element also came into play when the US exempted Chinese-made smartphones from higher import levies – the number one Chinese export to America by value – when the inflationary impact of smartphone tariffs became clear. It was a small de-escalation in a much bigger dispute but it highlights that there are some people in the US Administration who appear to understand the risks of escalation.

Another game theory concept highlights what can happen if actors in the dispute focus purely on the pursuit of their goals – Martin Shubik’s dollar auction problem which I originally used as a demonstration of the irrationality of Brexit negotiations. In brief, the dollar auction problem is a two-person thought experiment in which a dollar is initially auctioned off at a substantial discount to its face value. In subsequent rounds the price is bid up, with the highest bidder winning. But the twist is that the loser must also pay their bid. Consequently, both bidders have an incentive to continue bidding beyond the value of the prize in order to minimise losses, which results in a lose-lose outcome.

In the trade context, neither China nor the US wants to look weak in the eyes of the world leading to a cycle of escalating tariffs, even when both countries incur economic losses. The rational solution to this problem is to back down early or find a co-operative solution which minimises losses for both sides. Unless this approach is adopted, the key lesson highlighted by the dollar auction paradox is that once the bidding process becomes entrenched, the competing parties lose sight of their original goals and produces an outcome where the costs of winning outweigh the cost of defeat.

Credibility and how to lose it

One aspect of Schelling’s work that has not been adhered to is the principle of credibility. Schelling made the point that in strategic interactions, the ability to credibly commit to a course of action conveys a decisive advantage and that threats and promises must be credible to be effective. In the case of trade, however, Trump has not acted credibly. He has backtracked on his tariff policies on a number of occasions, leading many to wonder whether he is bluffing. While Trump sets great store by the art of the deal, the art of the bluff can take you a long way in life, love and poker. But bluffing only works if opponents believe the bluffer will follow through. While Trump has the power to impose tariffs, the question is whether doing so is politically or economically wise. According to a recent poll, 56% of respondents disapprove of his handling of the economy while 75% believe tariffs will push prices higher in the short-term. If Trump were attempting a further run for the White House, it would be politically dangerous to go further with the tariff policy. But because he is not bound by this constraint, further trade escalation cannot be ruled out, especially since 34% of poll respondents believe Trump's economic policies will pay off in the long run (admittedly down from 41% at end-March).

In game theoretic terms, a key weakness of Trump’s approach is that he takes a zero-sum approach to strategy – in other words, winner takes all and the loser gets nothing. This might work in the casino business – although Trump’s record as a casino owner is terrible, having twice filed for Chapter 11 bankruptcy – but it does not work in politics. One reason for this is that politics is not a one-shot game in which strategy is formulated without any concern for future consequences (as the dollar auction problem illustrates). Geopolitical decision making is a multi-shot game in which today’s actions have an impact on future decisions. For example, the US may ultimately need Europe onside if it is to successfully pursue its economic policy with regard to China. But by damaging relations with Europe today through its approach to both trade and security, it becomes less likely that Europe will side with the US in future.

We cannot continue in our game theory mode without talking about a Nash equilibrium – a situation where no player can improve their outcome by unilaterally changing their strategy, assuming the other players keep their strategies unchanged. Since high US tariffs hurt domestic consumers, the US might improve its welfare by lowering tariffs — even without immediate Chinese reciprocity. This suggests that the current position does not represent a stable Nash equilibrium. But since US tariffs also make China worse off, China has an incentive to reciprocate by reducing its own tariffs. Rolling this forwards, both sides engage in tariff reduction until the point at which we reach a stable welfare position. Such a strategy works because it builds trust gradually and is credible, even in the absence of explicit cooperation.

Trust busting

Looked at from a logical standpoint, Trump’s trade policy appears inconsistent because (a) it will make US consumers worse off and (b) he has not followed through on his calls, undermining their credibility. Against that, his policy could be seen as a form of calculated ambiguity or strategic brinkmanship, with Trump attempting to pressure trading partners into concessions and rallying domestic support by appearing strong on trade. By merely postponing tariff implantation, Trump keeps everyone off balance, thus enhancing his leverage and keeping his threats alive without fully committing.

Perhaps the best definition of the current situation is one of strategic ambiguity, based on the goal of retaining flexibility in order to exert pressure and manipulate expectations. Such a strategy might work if the short-term volatility serves a longer-term purpose, but other than putting maximum pressure on China, it is hard to see what the longer-term plan is. At some point Trump has to commit on tariffs one way or the other but when he does, he will have to accept the consequences. America’s putative allies may be amenable to Trump’s threats but China most certainly is not.

Last word: Common sense is not so common

All of this may sound like obvious common sense – don’t escalate conflicts that hurt both sides, don’t bluff unless you’re willing to follow through, and don’t ignore the long-term consequences of short-term moves. Yet time and again, these lessons are ignored in the heat of political battles. This is where game theory proves its value: not as an abstract academic exercise, but as a practical framework for understanding strategic behaviour and anticipating outcomes. By highlighting the incentives, interdependencies, and likely responses of all players, the theory of games offers a rational lens through which to view even the most irrational-seeming policies.

Trading places

Hiding in plain sight

Since his inauguration as US President, Donald Trump has turned the world upside down, as he indeed promised on the campaign trail. Like many people, I have underestimated his determination to follow through on issues such as trade policy and the nature of his relationship with traditional allies, especially in Europe. Although Trump’s bark proved to be worse than his bite during his first term in office, the restraints have come off this time around given the changed nature of his Administration which is much more ideological in nature. That said, Trump has consistently espoused an “America first” strategy – the clue was always in the name – and the President is only acting in line with the Henry Kissinger doctrine that “America has no permanent friends or enemies, only interests.”

One reason for misreading Trump is that his definition of American interests differs from those who see American leadership as rooted in alliances, democratic values and global stability. In this framework, the US sees itself as a stabilising force in global affairs, willing to bear costs to uphold a rules-based international order which allows it to exert its soft power. By contrast, Trump prioritises transactional relationships and a narrower, more nationalist view of US interests, placing more emphasis on short-term gains, economic advantage and the assertion of US sovereignty over collective global commitments. This explains his scepticism towards NATO; his withdrawal from international agreements like the Paris Climate Accord and the WHO, and his willingness to engage with authoritarian leaders based on perceived strategic or personal benefit rather than ideological alignment. For those accustomed to the traditional American foreign policy playbook, this divergence creates misunderstanding. Critics may interpret his actions as erratic or uninformed when, in reality, they follow a consistent logic – one that prioritizes strength, economic leverage, and a rejection of international obligations that he perceives as constraints rather than assets.

But this does not mean that the strategy is optimal – certainly not for the western allies, nor indeed for the US. Despite what Vice President Vance might think, the US and Europe share many common values and there is a benefit to keeping one’s allies onside. Indeed, the only country to invoke NATO Article 5 – the principle of collective action in the event that a member of the alliance is attacked – is the United States in the wake of the 9/11 attacks. Elon Musk’s closeness to the Trump Administration may be one reason why Tesla sales have slumped in Europe, falling in March by 36.8% and 63.9% year-on-year in France and Sweden, respectively. This in turn suggests that Europe may be less willing to erect trade barriers against Chinese products if it can supply better and cheaper products than the US (ignoring for the time being that the EU has already imposed tariffs on Chinese EVs). The wider point being that there may well be economic blowback on the US if the Trump Administration fails to recognise the longer-term consequences of its actions.

This time may be different … or it may not

One of the least trustworthy phrases in markets is “this time is different” – one which is invoked every time a new paradigm appears likely to upset the status quo. Consequently, we should be wary of drawing too many conclusions from the current shenanigans emanating from the White House. We cannot know, for example, whether the current breach in relationships within the western alliance will extend beyond Trump’s term in office (whether that will include a third term remains to be seen). History may provide some clues.

In the 1930s, for example, the US pursued a policy of isolationism which advocated non-involvement in European and Asian conflicts and non-entanglement in international politics. This was stoked by Republican Senator Gerald P. Nye, who claimed that American bankers and arms manufacturers had pushed for US involvement in World War 1 for their own profit, costing many lives while not serving US interests. This was compounded by the Great Depression, which forced Americans to concentrate on their domestic economic problems. Had it not been for the Japanese attack on Pearl Harbor in 1941, the world’s geopolitical history might have been very different.

Domestically, there are also parallels with the McCarthy era of the early-1950s when paranoia regarding “reds under the bed” resulted in huge political upheaval in Washington. The parallels are not exact, of course, since history does not repeat exactly, but it does rhyme occasionally and there are some elements of McCarthyism which chime with Trump’s modus operandi. Perhaps most obviously, Senator Joseph McCarthy used anti-communist fears to rally support, claiming that the US was riddled with communists (here for his famous “Enemies from Within” speech in 1950). McCarthy’s suggestion that “a moral uprising [that] will end only when the whole sorry mess of twisted warped thinkers are swept from the national scene” has echoes of Trump’s promise to “drain the swamp” and crush the “deep state”.

Like McCarthy, Trump has initiated attacks on the institutional framework of the United States: In McCarthy’s case, he launched a number of unfounded attacks on prominent individuals while Trump has variously railed against the FBI, the DOJ and the mainstream media. Both used the media to spread their message (quite how McCarthy would have adapted to social media is a fascinating what-might-have-been), sowing dissension and polarisation. Both also suffered a fall from grace with McCarthy’s influence fading after the infamous army hearings of 1954 while Trump has twice been impeached, found guilty of criminal offences and lost a presidential election. But while McCarthy quickly faded from the scene once the Republican Party realised he was more of a liability than an asset, Trump’s political career has bounced back.

Where the parallels end is that Trump controls a major political party with a much wider base of popular support whereas McCarthy was just a Senator with a genius for self-promotion. It may yet be the case that the Republicans abandon Trump if his strategy proves to be ruinous for the US but he will not fade into obscurity as did the Senator from Wisconsin. There are many in the GOP who buy into Trump’s views – his is not a one-man crusade. And while public opinion has indeed shifted against Trump – latest polls put his approval ratings at 47.9% versus 50.5% at the start of February – this is far from catastrophic, and is in any event higher than at any time in his first term (see chart below).

It’s the economy, stupid

Donald Trump’s political fortunes will depend heavily on US economic prospects. Goldman Sachs recently raised its subjective assessment of a US recession in the next 12 months from 20% to 35% while JP Morgan puts the prospect of a global recession at 40%. These numbers suggest that the odds are still against a downturn but they are rising. Moreover, given the strength of the economy bequeathed to Trump, voters may not be very forgiving of a self-inflicted economic downturn, especially if tariffs have a material impact on the prices paid by American consumers. What really matters from a political perspective is the depth of any recession. It is possible that the Administration could spin a mild correction as the price for taking back control though that might be a risky strategy. But a more aggressive downturn would unlikely play well, given the impact this will have on jobs and incomes. With the US midterm elections scheduled for November 2026, Republican party strategists will be aware that such an outcome runs the risk that they will lose control of Congress.

Key takeaways

The commentariat has spilled much ink in predicting the implications of a Trump presidency and while history suggests it is wise to ignore some of the more excitable predictions, there is little doubt that we are operating in changed geopolitical circumstances. Europe no longer considers the US a reliable partner, and while that may change post-Trump, governments do not have the luxury of time to wait him out. As The Economist put it: “There was a time when America’s allies could count on it to do right by them, even if they got into arguments. These days, by contrast, America’s allies have to prepare for the worst.” As for Trump’s domestic position, it is too early to tell whether voters are buying into his economic strategy. But polling evidence does suggest that there has been a sharp rise in the share of Republican voters who believe the EU is unfriendly – perhaps hardly surprising in view of Trump’s claim that the EU was “formed in order to screw the United States”. By the same token, European voters clearly have a less positive view of the US.

Whether the “special relationship” between the US and Europe can recover from this remains to be seen. As in a marriage, once one partner demonstrates reduced commitment, it reduces the incentive of the other party to hold it together. At the very least, this will lead to estrangement; at worst, divorce. But even a divorce can be amicable.