2026: TrAIumphalism

If 2025 was the year when artificial intelligence escaped the laboratory and Donald Trump escaped political gravity, 2026 will see the consequences of these events play out further on the global stage. It will be another year dominated by political and policy uncertainty, with cyclical economic considerations likely to take a backseat as policymakers grapple with changing geopolitical circumstances. That said, worries of a bursting of the AI bubble will keep policymakers on their toes, as markets party like it was 1999. However, the crucial difference between today and the dawn of the millennium is that we are no longer basking in the glow of the peace dividend that formed the backdrop to the economic environment of the time. Consumers are anxious; governments are heavily indebted and policy choices are more constrained. Buckle up for another trip around the sun.

Rampant Trumpism

Trade policy dominated the first half of 2025 as President Trump followed through on his threat to use tariffs as a means of extracting concessions from trading partners. By September 2025, the average effective US import tariff rate stood at 10.65%, up from 2.2% in January. Analysis conducted by UPenn Wharton suggests that tariff rate changes generated $124.5 bn in net customs revenue in the first nine months of 2025, while importer shifts in purchasing behaviour reduced potential revenue by only $31.5 bn. In other words, they achieved the goal of revenue generation without derailing the economy, which may embolden Trump to further weaponize trade. But the longer-term effects have yet to feed through. Consumers do not like paying higher prices while the full impacts on growth and inflation have yet to be felt. Bottom line: We can expect to hear more on Trump and tariffs in 2026.

Meanwhile, Jay Powell’s term as Fed Chair will end in May. Concerns that his successor will be more willing to accede to Trump’s demands for looser monetary policy in order to boost growth has the potential to undermine Fed independence. Markets will be keeping a close eye on this issue.

But it is in the realm of geopolitics where Trump will have the biggest influence. In 2024 he promised that “when I’m back in the White House, we will expel the warmongers, the profiteers … and we will restore world peace.” Admittedly, he did enforce a deal in the Middle East in 2025, but this is honoured more in the breach, and he has had no impact on ending the war in Ukraine, despite promising in June 2024 that “I will have that war settled between Putin and Zelenskyy as president-elect before I take office.” Indeed, Trump’s casual disregard for Russian activities close to NATO’s borders (and sometimes inside them) has undermined trust in US willingness to guarantee European security. US military strikes against Iran and Nigeria demonstrate that Trump is not shy about projecting force. But the January 2026 action to overthrow Venezuelan president Maduro, with Trump promising to run the country “until such time as we can do a safe, proper and judicious transition” has raised question marks around whether his foreign policy is ultimately guided by a coherent vision of peace or by transactional calculations that vary from case to case. The result is not disengagement, but an erratic form of activism that has left allies uncertain, adversaries emboldened and global risks harder to price.

As The Economist noted at the end of 2025, the main beneficiary of Trump’s bombast is China. It resisted US tariff pressure, exposing how dependent America and its allies remain on Chinese manufacturing value chains. Moreover, Trump’s strategy has often played into China’s hands. Bilateral tariffs alienated allies rather than building a coordinated response, while attacks on science funding, immigration and foreign researchers will ultimately weaken America’s innovative edge.

The 2026 Midterms may act as a check on Trump’s ambitions. The smart money suggests that the House of Representatives is likely to come under Democratic control following next November’s elections, with the result that a divided Congress will mount some serious opposition to his plans. History is on the Democrats’ side: Only twice in 14 Midterms since 1970 has the House majority aligned with the President’s party. In addition, Trump’s net approval ratings are in negative territory, though admittedly by less than at this point during his first term (although his approval rating has dropped faster, albeit from a higher starting point in 2025). But it would be unwise to fall back on historical patterns to justify betting against him – after all, this is a President who revels in tearing up the rulebook.

AI caramba

Progress in AI will continue to dominate the economic conversation. The most pressing concern for policymakers is the prospect that the AI bubble will burst, dragging down markets in its wake, in much the same way as happened in 2001 following the deflation of the tech bubble. This is a valid concern: Market concentration is high, with the Magnificent 7 accounting for 34% of the S&P500 market cap. Market valuations also look exceptionally toppy, with Robert Shiller’s CAPE measure estimated to have reached 39.4x in December – a value exceeded only in 1999-2000 on data back to 1881. Indeed, the OBR was so concerned about the prospect of spillover effects from a global equity price correction that the November EFO included a scenario in which a 35% decline in equity prices was estimated to produce a 0.6% reduction in UK GDP in 2027-28. It is not only the financial markets which are increasingly AI dependent: In the first half of 2025, business investment in information processing equipment accounted for the bulk of US GDP growth. Any reversal of the AI boom could have significant impacts on the real economy.

While caution is warranted, there are significant differences to the 1999-2000 boom. The current AI cycle is driven by profitable, cash-rich companies which are experiencing robust demand for their products. Admittedly, expectations have outstripped earnings growth as investors engage in a process of price discovery in a wholly new environment, so some wobbles are likely along the way. But there is real demand for the products emerging from the latest AI revolution, backed by an emerging infrastructure. A key trend in 2026 will be the continued shift from experimentation to integration as corporates begin to embed generative AI tools more deeply into core business processes. This will drive productivity gains, although these are likely to be uneven and manifest in ways that are hard to measure in conventional statistics. As with past general-purpose technologies, the biggest effects will come not from flashy applications but from mundane process redesign: faster coding cycles, cheaper discovery processes and increasingly automated customer support functions.

This may add to social tensions as large companies with data, capital and managerial capacity pull further ahead, while smaller firms struggle to keep up. There are increasing concerns that graduate entry level jobs will feel the AI squeeze as white-collar occupations once thought relatively insulated from automation become vulnerable to the application of new technology. The political significance of this phenomenon will increase in 2026, especially as it collides with an already febrile debate about inequality, immigration and cultural change. We see these concerns manifested in the rise of political populism across Europe and the US. 2026 will likely see further declines in the popularity of centrist politicians (Emmanuel Macron and Keir Starmer to name but two) as they struggle to manage the fallout from these competing forces and deliver a return of the feelgood factor that they have long promised their electorates.

Other things to watch

In the absence of any shocks, there are few things to get excited about on the macro front although fiscal policy across the industrialised world remains an area to watch. In the US, Trump’s bias towards tax cuts balanced with (theoretical) spending restraint may start to put some strain on Treasury markets, especially if the new Fed Chair is perceived as soft on inflation. Across the wider world, high debt levels and interest rates which are considerably higher than four years ago will limit government’s room for fiscal manoeuvre. Markets are unlikely to be prepared to fund unlimited borrowing, while voters are not willing to pay higher taxes. This can has been kicked down the road for so long that it is one that most people ignore. We may do so at our peril.

Geopolitically, the world remains unsettled. The risk in 2026 is less of sudden escalation than of chronic instability as conflicts drag on, diplomatic frameworks weaken and international institutions struggle to command authority. For businesses and investors, the defining challenge of 2026 will be navigating a world where technological acceleration coincides with political friction. Scenario planning will become a core managerial skill as businesses will have to adjust rapidly to changing economic and geopolitical currents.

Clearly, 2026 will not be a year of calm. It will be a year in which the forces unleashed in the first half of the decade take firmer shape as we take another step along a road increasingly less framed by the post-1945 settlement. Never was Yogi Berra’s aphorism more apt: “The future ain't what it used to be.”

Relative Claus

It is ten minutes to departure time at the North Pole, and Alfie Smith is annoyed. Not existentially annoyed. Not haunted-by-the-weight-of-global-expectations annoyed. Just irritated. His PlayStation game has been paused mid-mission, and the screen is flashing that passive-aggressive message about inactivity.

“Honestly,” he says in an accent which could place him anywhere from Acton to Zimbabwe, tugging at the red jacket with the mild resentment of someone who did not choose this outfit. “Five more minutes and I’d have cleared the level.”

This, apparently, is Santa Claus.

Not the rotund, bearded figure of myth, but a skinny 21-year-old with messy hair, trainers and the posture of someone who grew up hunched over a console. The beard is clipped on; the suit adds considerable heft; the laugh is optional. The job, he insists, is real.

“People always ask why Santa isn’t old and fat,” Alfie says. “But you try being out of shape in this job. If you think working in an Amazon warehouse is hard on the system, wait until you have to get around the world in about 24 hours, dropping presents as you go.”

Alfie reckons he trains hard to be in shape for his big night, though you would not think so to look at him. He looks more like someone who has trained his thumbs far more diligently than the rest of his body. For 364 days of the year, you would pass him by without a second glance. Which is precisely the point – you can't be Santa for 365 days a year. It is the very definition of a part-time job.

Alfie is vague about what he does for the rest of the year. He volunteers that he works “in computing”, and says it in the way people do when they don’t want to explain the rest. Later, he admits that he is very good at getting into places he is not technically supposed to be. This has proved useful in both his professional life and on Christmas Eve, when an increasing number of households appear to have mistaken “secure” for “Santa-proof”. He won’t be drawn on the issue of cyberattacks on JLR and Marks and Spencer. “Trade secrets mate,” is his only comment.

A young person’s game

The Santa role, it turns out, is not a lifetime appointment. In an inversion of the old slogan, the job is for Christmas, not for life. It’s rotational.

“You can’t have a single individual doing global overnight logistics indefinitely,” Alfie explains. “Fatigue effects, declining marginal stamina, rising injury probability. Dad did it for years, but the system’s changed. Weight is a disadvantage when aerodynamics and roof landings are involved.”

Santa, like many institutions, has modernised. Each Santa serves a fixed term, usually starting in their early twenties when reaction times peak and knees still function. The old image persists, Alfie says, because of branding. And what a brand! Alfie is aware that he is upholding a centuries old tradition. “You definitely don’t want to mess up on the job. After all, look what happened to the Prince formerly known as Andrew. And I’m out there on my own. A misplaced yo-ho-ho and we’re all out of business.”

It is not as if the Santa business has the field all to itself these days. “Amazon are good,” says Alfie, “but they’re not in our league. I mean, if you’re not in, they have to leave a parcel out in the rain or with a neighbour. We deliver to your living room exactly when we say we will.” But he admits Amazon have come a long way in 25 years. There was talk of them dressing their drivers as Santa around the Christmas period “but our lawyers put a stop to copyright infringement,” interjects Fred Smith.

Keeping it in the family

Fred Smith is Alfie’s father and a former Santa himself. He watches from a nearby chair, nursing a mug of something strong and steaming. Fred does look a bit closer to the archetypal Santa figure with his greying hair and carrying a few extra pounds. He took over the round from his father, who in turn took over from his father before him. Family legend has it that the lineage can be traced all the way back to the fourth century Greek Bishop Nicholas, or Old Nick as Fred calls him. The records suggest the line can be traced back to the late Middle Ages, though this depends on how strictly one defines “records”. One ancestor, known only as Old Tom Smith, appears in a fifteenth-century parish ledger as a man who was “frequently abroad at night”, usually carrying a sack, and always returning lighter than he left – unlike his brother William, a noted burglar. Another is mentioned in the margins of a monastic text, accused of “entering the nunnery uninvited, distributing items of unclear origin, and insisting it was for morale”.

By the seventeenth century, the role had become more formalised. A distant ancestor, Edmund Smith, is said to have standardised the red coat “for visibility in poor winter light” and introduced the first sack, after repeatedly losing gifts in snowdrifts. Industrialisation brought challenges. One Victorian Santa Smith struggled with the sudden explosion in toy variety and decided to simplify his job by giving every house an orange and a lump of coal. This did not go down well. Lessons were learned.

The twentieth century was particularly hard on the family. Two world wars disrupted routes, lists and morale. Fred’s grandfather was reportedly forced to deliver presents by bicycle when the reindeer asked for danger money. By the time Fred took over, the job had already begun to modernise. Chimneys were shrinking, expectations were rising, and mince pies had become increasingly experimental. Still, the principle remained the same: turn up, don’t wake anyone, and never, under any circumstances, miss a house.

Fred takes a sip from his mug. “People think Santa’s immortal,” he says. “He isn’t. He just keeps handing the job down.”

He pauses. “Like the crown,” he adds. “But colder.”

Getting around

These days the sleigh is no longer pulled purely by reindeer. Not because the reindeer can’t handle it – they can – but because scale matters.

“Reindeer are great,” Alfie says. “But capacity constraints are a real problem.”

The modern operation uses a hybrid system: reindeer for symbolism and short-haul rooftop work, supplemented by what Alfie describes as “non-disclosed propulsion technology.”

“We don’t like to call it magic anymore,” he adds. “It’s bad for investor confidence.”

The route planning is algorithmic. Time zones are exploited ruthlessly. Sleep is not an option.

“You’re basically arbitraging time,” Alfie explains. “By moving east, you keep buying yourself more night. The whole thing is a window of opportunity, and demand for on-time delivery is perfectly inelastic. Every household wants delivery by morning. No excuses.”

Fred laughs. “In my day, you just went east and hoped for the best.”

Around the world in 24 hours

Alfie’s favourite part of the job is the flying. His least favourite part is the living rooms.

“You see everything,” he says. “The good, the bad, the aggressively beige.”

What makes the job worthwhile, though, is the people you meet – or rather don’t meet if all goes to plan. “People say kids don’t believe anymore,” Alfie says. “They absolutely do. Adults, though? Adults leave the weirdest stuff out. Kale. Gluten-free crackers. One year someone left spirulina.”

He pauses.

“I still ate it. Sunk cost.”

Economically, Alfie says, Christmas is fascinating.

“You see inequality very clearly. Some houses are overflowing. Others are sparse but careful. You learn quickly that value isn’t about quantity.”

He describes one small flat where a single present sat under a tiny tree.

“It was wrapped three times,” he says. “That’s effort. High labour input.”

Fred nods.

“The best gifts are always like that.”

Learning on the job

Last year was Alfie’s first solo effort. Mistakes were made.

“There was a misjudged landing in Manchester,” he admits. “Satellite dish. I took it clean off.”

He grimaces.

“Technically it was infrastructure damage. We had to compensate. Fortunately I had a spare on the sleigh.”

There was also an incident involving a security system in Munich, a drone in California, and what Alfie diplomatically calls “a near-miss with an unidentified anomalous phenomenon.” It turns out he does not believe in little green men. “They’re blue,” he adds quickly.

“But you have to learn on the job smartish,” he says. “The margin for error is thin, and people are always trying to catch you out.”

Fred snorts.

“At least you’ve got GPS – Global Position of Santa. I navigated by instinct and a vague sense of dread.”

Fred’s era, by all accounts, was tougher. No real-time data. No dynamic rerouting. Just a sack, a list and an understanding that failure was not an option.

“And we were heavier,” Fred adds. “Which was a mistake.”

Fred Claus

Fred took on the Santa role in his early-twenties and stayed longer than was healthy.

“Of course the job was a lot harder in my day,” Fred says, “When I did it we ate what we could, when we could. No route optimisation. No GPS. Point the reindeer where we wanted to go and hope we would get round without mishap.” He shakes his head. “Terrible for productivity.”

“There was pride in it,” he says. “But the workload kept rising. More kids, more stuff, more expectations.”

Globalisation, it turns out, was not kind to Santa.

“When supply chains improved, people expected more,” Fred says. “More variety, more precision. Try explaining inventory management to a seven-year-old.”

He gestures toward Alfie.

“This lot have dashboards. KPIs. Recovery protocols.”

Alfie shrugs.

“Still hard. Just differently hard.”

The economics of belief

At its core, Alfie says, Santa’s job is about expectations management.

“The gifts matter,” he says. “But belief is the real public good.”

Belief, he explains in language befitting an economist, is non-rival and non-excludable. Everyone benefits when it exists, and no one household can produce it alone.

“That’s why Santa has to be centralised,” Alfie says. “If it were privatised, you’d get under-provision.”

Fred smiles.

“Never thought I’d hear Santa described as a natural monopoly.”

As departure time approaches, Alfie stands, stretches and checks his watch.

“Right,” he says. “Time to go.”

He pulls on the hat, adjusts the beard, and suddenly looks convincing.

Any last thoughts?

He considers.

“People think Christmas is a season of goodwill,” he says. “But for many, it’s really about effort, timing, efficiency – and showing up when it counts.”

He pauses, then adds:

“And surviving the spirulina.”

The grotto doors open. Cold air rushes in. Reindeer snort impatiently.

Fred claps his son on the shoulder.

“Don’t forget,” he says. “Eat the mince pies. They’re baked into the system.”

Alfie grins.

Then this year’s version of Santa Claus sets off into the night, as he has for generations, though now with better tracking software.

Merry Christmas to you and yours.

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.