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.

Light the blue touchpaper

Rishi Sunak’s announcement last week that the UK is to hold a general election on 4 July represents the fourth major UK plebiscite since I started this blog in 2016 and the sixth in 10 years (including the 2014 Scottish referendum). Of them all, the 2024 election feels the most necessary. The Conservatives have occupied Downing Street since 2010, chewing up five prime ministers, while contending with the fallout from Brexit, the pandemic and a rapidly shifting geopolitical world. After such a gruelling run, they look tired and bereft of ideas.

It happens: The business of governing is hard at the best of times, and these are not the best of times. All governments run out of ideas eventually but this particular incarnation of the Tory party ran out of steam earlier than most. While it can point to mitigating circumstances in the form of the pandemic, it has made a series of unforced errors that have contributed to its unpopularity. Although it made mistakes prior to 2016 (who didn’t?), the Brexit outcome changed the calculus. The government chose to accept a close-run advisory plebiscite as a winner takes all contest with no plan how to deliver. Not only did it waste considerable amounts of political capital trying to reach an accommodation with the EU but it failed to implement any of the changes that were promised by Brexit proponents. Even more egregious was its failure to understand the lessons of the 2019 election. The thumping majority gained by Boris Johnson was not a vote in favour of populist nationalism, as many in the party believed, but the imprimatur of an electorate willing to believe Johnson’s claim that he could finally get Brexit done and – equally importantly – was a repudiation of the policies espoused by Jeremy Corbyn.

There are no guarantees in politics but it is a raging certainty that Labour will win the next election. Latest bookmakers odds put the probability of a Labour win at 89.8% versus 4.3% for the Tories (and a 14.9% likelihood of a hung parliament). Although bookies odds reflect the weight of money being placed rather than an objective assessment (see this post from 2019), the fact that a record number of 83 Conservative MPs have so far opted to stand down, rather than contest their seats in July, is one indication of the party’s pessimism. Electoral Calculus currently estimates that Labour will win 479 seats (see below) which would give it the biggest majority (308) of any government since 1918 (bar the emergency National Government of 1931). For the record, I would be astounded if such a majority is achieved - Labour will do well to emulate Blair's 1997 landslide.

Defining the battleground: Recapturing the feelgood factor

The economy will be one of the key areas where Labour and the Conservatives will lock horns during the campaign. Sunak’s quite literal damp-squib announcement on Wednesday argued that: “Our economy is now growing faster than anyone predicted, outpacing Germany, France and the United States. And this morning it was confirmed that inflation is back to normal. This means that the pressure on prices will ease, and mortgage rates will come down. This is proof that the plan and priorities I set out are working.”

This is not wholly wrong, but not wholly right either. It is true that UK growth outpaced the three other countries in Q1 2024 but since 2016 has outpaced only Germany. In any case, it is not just the rate of growth which matters: IMF data suggest that UK real incomes per head are almost 30% below US levels and 12% below German levels (chart above), with the rankings not having changed much since 2010 (indeed, they have widened relative to the US). One potential cause of the dissatisfaction with government in recent years has been the extent to which voters do not feel better off. It is important to recognise at the outset that this is not simply a problem in the UK: It is an issue across much of the industrialised world, notably Europe. But this cuts no ice with voters who, not unsurprisingly, are focused on their own domestic issues. The Conservative government of 1979 to 1997 delivered real household disposable income growth averaging 2.7% per annum, while the Labour government of 1997 to 2010 presided over annual growth of 2.5%. Since 2010, this has slowed to 1.3% (chart below).

This is a reflection of changed circumstances following the GFC in 2008, with the slowdown in productivity growth at the heart of the problem, slowing to around 0.5% per year versus 1.5% pre-2008. The Productivity Institute has identified three key reasons for the UK’s sluggish performance in this regard: (i) Underinvestment, in both physical and human capital; (ii) Inadequate diffusion of productivity-enhancing practices from the innovation-driven sectors areas to the wider economy and (iii) Institutional fragmentation and lack of joined-up policies, aggravated by the dichotomous arrangement whereby the policy formation process is highly centralised but the institutional framework responsible for translating this to the wider economy is  highly fragmented. None of these will be an easy fix, but they will require a root-and-branch reform of the policy formulation process. Market solutions alone will be insufficient to deliver the desired outcomes, and certainly not on a five-year horizon.

The fiscal constraint

One of the key issues that voters care about is the state of the UK health and social care sectors. Public dissatisfaction with the NHS reached an all-time high in the 2023 Social Attitudes Survey, reaching 52% compared to the previous peak of 50% in 1997. Ironically, given the current government’s desire to reduce taxes, almost half of voters support a policy of raising taxes to provide additional NHS funding. With an ageing population placing increased strain on the health services at a time when post-pandemic strains and funding challenges have raised pressure on the system, there may be little option but to test the public’s willingness to pay higher taxes. The alternative may be to explore more radical funding options, such as a continental European-style social funding model; increased hypothecation; raising NHS charges or relying on greater private sector provision.

None of these are likely to be very palatable to the electorate but with the UK’s debt-to-GDP ratio already at its highest in 60 years, at around 100%, and competing demands from defence and managing the green transition, the fiscal constraint is increasingly biting. It is thus clear that the UK will require a serious debate about its policy choices in the next parliament. At the very least a radical reform of the tax system should form part of the political and economic debate with nothing off the table. Even if they are not adopted, it is necessary to have a debate about the pros and cons of wealth taxes and land taxes, if only to widen the nature of the debate.

Final thoughts

In some ways, the 2024 general election will not be a good one to win. Many challenges lie ahead and they will require the next government to make some unpopular choices. Just as 1979 marked a break with the post-1945 political consensus, so it is time to make a break with the post-1979 settlement which has peddled the view that it is possible to reduce the size of the state and reduce taxes while simultaneously driving up living standards. Achieving the latter will require compromises with regard to the former and more radical thinking on a whole range of issues. But as this bitter election campaign gathers momentum, voters will do well to remember that there are no quick fixes to the economic problems facing the UK. Liz Truss reckons there are Ten Years To Save the West, and while I am not in the habit of taking lessons from one who failed to outlast a lettuce, ten years to fix the economy might not be too far wide of the mark.

The (un)changing face of politics

Although I have tried hard to steer clear of politics on this blog over the last year or so in order to focus on the economics, in many ways the two subjects are intertwined. The onset of the global financial crisis in 2008 raised a number of questions that politicians have failed to answer, with the result that the discontent which was already bubbling under the surface spilled out in ways that mainstream politicians have been unable to counter. Populists and authoritarians have had a field day, giving us Orban in Hungary; the Law and Justice Party (PiS) in Poland, not to mention Trump in the US and the Brexit crowd on this side of the pond. But the complexities of real life conspire to confound the simple appeal of many populists, with the result that PiS is a diminished (though still important) force in Polish politics; Trump is out of office (for now) and the gang of zealots that inflicted Brexit upon the UK seem to be fading away into the background.

Indeed, for a long time the British government has appeared to be drifting inexorably to the right, engaging in culture war rhetoric rather than attempting to tackle some of the bigger economic and social problems facing the UK. The sacking of Home Secretary Suella Braverman (the reasons for which you can read here) perhaps marks a watershed as Prime Minister Rishi Sunak realises that the further towards the fringes his party goes, the less likely they are to escape a major trouncing at the next general election, which is expected to be held anytime in the next 6-12 months. The surprise return of former PM David Cameron as Foreign Secretary is the big news, both at home and abroad, and is a sure sign that Sunak is attempting to drag his party back towards the centre before it is too late. If nothing else, it may reassure Tory voters in the shires who have increasingly found the current incarnation of the party unpalatable.

Whether or not Cameron will be the right person to convince the electorate is moot. After all, he is widely blamed for losing the Brexit referendum and ushering in a series of prime ministers who proved themselves more inept than their predecessor (Sunak broke that trend, although he did follow Liz Truss, whose main claim to fame in the eyes of many voters is that she was outlasted by a lettuce). And in an irony that has not gone unnoticed on social media, since Cameron is no longer an MP, he can only enter government by sitting in the House of Lords and cannot be held to account by the House of Commons. Remind me again, but wasn’t one of the benefits of Brexit that we could get rid of unelected bureaucrats?

While it is certainly possible – indeed likely – that changing the composition of his government will allow Sunak to eat into Labour’s polling lead, which has averaged 19 points over the past year (chart above), will voters be sufficiently pacified to draw a line under the last seven years of chaos? If the evidence which is emerging from the Covid inquiry is any guide, Conservative politicians of recent years have a lot to answer for. The tales of incompetence which emerged under Boris Johnson’s leadership will not easily be forgiven or forgotten, highlighting the extent to which governance has been compromised. The Truss government’s short-lived but chaotic tenure severely damaged the Conservatives’ reputation for economic competence while politically contentious decisions such as the cancellation of the northern leg of the HS2 rail project will do little to convince voters in the north that the Conservatives deserve another term in office.

It's the economy stupid

It is only four years since the last election and a lot of water has since flowed under the bridge. But one of the great consistencies of the intervening period has been the Conservative government’s failure to interpret the electorate’s mood in 2019. It did not win a huge mandate because the electorate was concerned about immigration or “wokeism” but rather because it wanted an end to the Brexit wrangling, which Johnson promised, and because Jeremy Corbyn was viewed as an unelectable leader of the opposition.

Matters have been compounded by the fact that the government has failed to deliver on its levelling up agenda – not altogether a problem of its own making, since the pandemic drove a coach and horses through that policy. It has also presided over the fastest rate of inflation in four decades – again the result of forces outside its control. However, it has doubled down on Brexit despite evidence that this is an increasingly unpopular policy, and voter satisfaction with the NHS has fallen to record lows, which is increasingly blamed on government policy (some of which is fair criticism, some of which is not).

Brexit is not to blame for many of the economic ills that the UK now faces, although it does compound them. Dissatisfaction over the state of public services is to a large extent the consequence of the austerity policy introduced by the Cameron government, which resulted in a two percentage point decline in the central government contribution to local authority financing (chart above). Increased unhappiness over the provision of services by public utilities is partly due to a lack of private sector investment following the privatisation of many of these utilities in the 1980s and 1990s. A policy of less government and more private sector involvement is thus not perceived by voters to be acting in their best interests. The debate is obviously more complex than that, but as I have pointed out many times before, the UK cannot afford to operate the same economic model as it did between 1979 and the onset of the GFC in 2008. Demographics are increasingly a headwind and there is no North Sea oil to fund tax cuts. Like all western economies, the UK looks set to experience a sharp slowdown in growth and a commensurate slowdown in the pace at which living standards improve.

As we look ahead to the next election, the party that does best will be the one that has a credible plan to tackle many of the UK’s underlying economic ills. How this will be done is a subject for another time. But changing government personnel does not sound like the game-changer that the UK needs. Forget culture wars and wokeism – the next election will be fought against the backdrop of the economy. Or as Bill Clinton’s strategist James Carville put it in 1992: “it’s the economy stupid”.

Alienation nation

It has been a hell of a month in the UK. Four weeks ago, the death of the Queen marked a symbolic shift in the institutional fabric, the implications of which we have yet to work out. Her funeral was an event televised around the world and confirmed that whatever else the UK does, it remains a world leader in pomp and ceremony and projecting its imperial past to relay an image of itself far beyond its significance as a modern global power. Four days after Her Majesty was laid to rest, the realities of modern Britain were highlighted by the government’s unveiling of what was described as the worst budget (sorry, not a budget – a fiscal event) of modern times – perhaps ever.

As an economic package it was gobsmackingly awful. For the full details, see here. But in short, the government (or perhaps we had better describe them as the latest collection of radicals to hold parliamentary office) outlined a Growth Plan with the stated aim of restoring the trend GDP growth rate to 2.5%. This entailed a series of supply side measures which amounted to unfunded tax cuts totalling £45bn or 2% of GDP. The rise in NICs announced last year will be reversed; planned increases in corporation taxes are to be scrapped; the basic rate of income tax will be reduced from 20% to 19% next April and it planned to abolish the higher rate of income taxation (45%) before it did a U-turn on the idea.

As a package of economic measures, it was always doomed to fail. First, the UK’s trend growth rate is hampered by unfavourable demographics so it will be hard to raise without a very big rise in productivity. The evidence does not support the notion that companies will boost investment in response to lower taxes, thus putting a hole in the productivity-enhancing rationale for lower taxes. In addition, an influential IMF paper in 2015 comprehensively debunked the notion that cutting taxes for the well-off has any impact on growth (“a rising income share of the top 20 percent results in lower growth – that is, when the rich get richer, benefits do not trickle down”).

As a political gambit, the fiscal event is probably the worst brand-destroying exercise since jeweller Gerald Ratner described his products as “total crap” and suggested that some of the earrings he peddled were “cheaper than a prawn sandwich from Marks and Spencer’s, but I have to say the sandwich will probably last longer than the earrings.” Ratner did not last long in the job after that. The findings by the Resolution Foundation that the richest 20% of earners will benefit from two-thirds of the gains from lower taxes may not directly have influenced voters, but they know well enough when they are getting a raw deal. This has contributed to Labour’s opinion poll lead widening from 12% four days ago to 24% today (chart below). Just as in 1992 when the perception of Tory economic competence was shattered by sterling’s ejection from the ERM, so the fiscal events of recent weeks could have the same impact on the current government.

Indeed, it was the pound that was initially the centre of attention in this fiasco as it briefly plunged to all-time lows against the dollar early last week. But it is the gilt market, where rising yields forced pension funds to scramble for cash to meet margin calls on their hedging instruments, where attention is focused and BoE action to calm the market (the merits of the BoE's actions are a subject for another day). To the extent that mortgages are priced off the gilt curve, rising yields imply that mortgage rates are likely to rise sharply, thus making life harder for households already facing a major cost-of-living squeeze. As it is, data from Refinitiv suggest that the 129 bps rise in 10-year gilt yields in September was the biggest monthly jump on record (chart below).

What’s next?

If the last few weeks have demonstrated anything it is that handing the keys to the kingdom to increasingly ideological governments is doing no favours for the economy or the majority of most of those dependent on it. Indeed as the excellent FT infographic (below) suggests, “out of 275 parties in 61 countries, the Tories under Trussonomics rank as the most rightwing of all” with the author concluding that “The Tories have become unmoored from the British people.”

It has almost become a cliché to repeat Dean Acheson’s 1962 quip that Britain lost an empire but failed to find a role but it goes to the heart of the Brexiteer fantasy that somehow leaving the EU would restore past glories. What many of us pointed out is that it would actually weaken Britain, exposing those weaknesses that could be masked by remaining within the EU. But at least Britain could console itself with the fact that it had a stable political system, not prone to chaos, and administered by a competent civil service.

Chaos is now the watchword in government and whilst the competence of the civil service is not in question, the firing by Kwasi Kwarteng of his most senior Treasury official sends a bad signal about the quality of advice the government can expect to receive. The fact that the OBR’s offer to provide an economic assessment of the government’s fiscal plan was rejected also calls into question the form of scrutiny to which the government is prepared to be subjected.

The fact that the government has back-tracked on cutting the 45% tax rate is a further forced error from both a political and market angle. It was slated to cost only £2bn and will not change the market’s view of the unfunded tax giveaway. The real error is failing to find ways to plug the revenue gap resulting from NIC cuts and income tax reductions. Markets will not easily be assuaged although the fact that yields fell following the announcement suggests that they expect more backtracking in the weeks to come. Politically, the government now looks weak because it has performed a U-turn despite Liz Truss’s assertion yesterday that she was committed to abolishing the 45% tax rate. Moreover, if market pressure does force the government to find savings, it may be forced to cut spending further. It is pretty certain this will not be a vote winner. Public services have been stripped to the bone in the last decade and voter appetite for further austerity is limited.

I concluded my last blog post more in hope than expectation by noting that “voters will be hoping that she [Truss] can deliver them out of the dark place into which Boris Johnson led them. Surely she cannot do worse. Can she?” A month in the job and she has more than lived down to expectations. Every prime minister it seems, manages to be worse than the last. This is not a cycle that the country can afford to continue. In the words of Martin Wolf in an unusually strongly worded FT opinion piece, “these people are mad, bad and dangerous. They have to go.”