Why governments should not be in hock to the bond market

 

My starting point is not what Andy Burnham said but points recently made by Chris Dillow. Here he argues that we shouldn’t worry about the bond market per se, because that market is just an early warning system for future problems that any government should be worring about anyway. In that sense, the bond market is no different from, and less important than, an OBR forecast.

For example, if the government were to start borrowing more to increase public spending, interest rates in the bond market might well rise, but this is only because additional public spending would generally increase the demand for resources, putting upward pressure on inflation. The government should worry about raising inflation, not the bond market anticipating this.

I think this argument is basically correct, but it needs a bit of elaboration. In particular, while arbitrage means the bond market is generally a predictor of future inflationary pressure, there are circumstances in which other factors might influence interest rates because arbitrage breaks down, as it threatened to do when the pandemic hit, or after the Truss fiscal event. In this post I will explore those possibilities, and suggest once again the government has little to worry about as long as the central bank is doing its job. In addition I want to explain why these basic truths are hardly ever acknowledged in the media, because acting as if the bond market is a vengeful god is just too attractive for most journalists.

Bond rates are interest rates on long term assets, so they depend on what investors think future interest rates on shorter term assets will be. If the two get out of line then there is an expected profit opportunity, and arbitrage is the process which drives those opportunities to virtually zero. As short term interest rates are set by the central bank, then the main influence on bond market rates are expectations about what the central bank will do in the future, which in turn primarily depends on what inflation will do in the future.

Any price that depends so heavily on expectations is likely to be quite volatile. This volatility is a gift to political journalists. If some political event happens, then there is a good chance that bond market rates will have subsequently risen, so they can write a story about that political event spooking the markets. That may be fair enough if that political event increases the chance that future inflationary pressure, but equally the movement in rates could be about something completely different. As Dominic Caddick notes, there were plenty of headlines about a ‘Burnham premium’ when rates rose in the early days of the Makerfield election, but no headlines when rates subsequently fell even though expectations he would win increased over time. Remember that most of the time no one actually knows why market rates move on a day to day basis.

Politicians and the public can safely ignore modest short term volatility in bond market interest rates. If more sustained increases in rates are due to growing expected future inflationary pressure then they should worry, but not because of what the markets are doing. They should worry because inflationary pressure is a problem in itself. Even if the central bank manages to suppress that pressure by raising interest rates, in normal circumstances higher interest rates discourage private investment and therefore longer term economic growth.

Doesn’t the link between bond market rates and the cost of borrowing mean that governments should worry about the markets whatever the reason that rates are moving? No, because the interest rate the government pays on much of its debt is fixed at the time the debt is issued, so rising rates only affect the much smaller amount of new borrowing. As a result the only reason governments should take note of the bond markets is if the markets are making intelligent guesses about future inflationary pressure.

A consequence of arbitrage is that the supply and demand for government debt is irrelevant to what the current market interest rate on government debt is, or more accurately demand for debt will adjust to ensure arbitrage holds. That in turn means that the budget deficit, which is a key determinant of the supply of new government bonds, is also irrelevant. Government deficits were highest after the Global Financial Crisis and interest rates steadily fell. Now of course current and future deficits, if they reflect additional government spending or cuts in tax rates, may indicate higher future inflationary pressure, so in those circumstances journalists are only half wrong if they write that higher deficits are increasing bond rates. But if deficits are rising because the economy is weakening then higher deficits will not raise bond market rates.

What is never the case for an economy like the UK is that interest rate movements reflect worries about government default. A country with its own central bank that borrows in its own currency cannot be forced to default by the markets, and debt would have to be orders of magnitude above current levels before any rational advanced economy government actually chose to default.

Arbitrage works most of the time, but sometimes it doesn’t, and those sometimes are the times we may well remember. Two related things can interfere with arbitrage: uncertainty and thin markets. If uncertainty about future short term interest rates increase, then the risk of holding long term government debt increases relative to holding shorter term assets, which means that investors will require a risk premium to hold longer term assets like government debt, and in extremis may decide to withdraw from the market altogether.

This is what happened during the onset of the pandemic in Spring 2020, when the markets stopped buying the debt of most governments completely. In its place central banks bought government debt instead (Quantitative Easing). With a recession likely, the last thing inflation targeting central banks wanted was surging longer term interest rates. Sometimes, however, uncertainty can be increased by government actions or inaction, and the central bank may be understandably reluctant to shield the government from the consequences of its own actions. That was a key factor in what happened after the Truss fiscal event, but before looking at that we also need to talk about thin markets.

Arbitrage works when there are lots and lots of potential buyers of government debt, so demand for debt can rise and fall depending on what the profit opportunities are. But occasionally that isn’t the case for UK government debt. These occasions are most likely to occur at times of high uncertainty, when lots of potential buyers stay out of the market because they are risk averse. The clearest case of that was in the final stages of the crisis following the Truss fiscal event, when for reasons I won’t go into rising rates meant pension funds had to sell off a large quantity of government debt very quickly. Supply increased, but because of heightened uncertainty caused by the fiscal event the demand to meet at rates implied by arbitrage wasn’t there, so rates rose. (My discussion of the market reaction to that event is here.)

On that occasion too the Bank of England stepped in and bought government debt. But its actions were limited, because it didn’t want to shield the government from the consequences of its own irresponsibility in announcing tax cuts whilst giving no clear indications of what spending cuts would be made, if any. This government irresponsibility meant it was quite right to call part of the rising level of bond market interest rates a 'moron premium'. 

These events, and what happened at the start of the pandemic, tells us that the Bank is prepared to intervene to restore arbitrage when the market is thin or external events create intense uncertainty, but not if greater uncertainty is created by the government itself fuelling inflationary pressure. Whether that warrants claims that the Bank ‘brought down the Truss government’ I will leave you to decide.

So do governments need to worry about the bond markets because sometimes arbitrage fails? Again the answer is no, because the central bank will intervene on those occasions. The exception is where greater uncertainty is caused by the government itself, but governments should worry about that in any case. Once again the bond market is just an indicator of underlying problems, and not in itself a constraint on what the government can do.

Why is it so rare for the media to acknowledge any of this, and act as if the bond market is some vengeful god that could strike at any point? First, when a Labour government is in power it suits journalists on the right to do this. Second, most people have no idea what arbitrage is and so it is much easier to pretend the actions of the bond market are mysterious and, for political journalists, highly political. As a consequence, journalists hardly ever acknowledge that the ‘market experts’ they like to quote have no secret knowledge about why rates move, and work for firms that make more money when governments tighten fiscal policy.

All this means policy that is based only on fears about the bond market, or worse still about what journalists are writing about the bond market, will be bad policy. Andy Burnham was right that governments should not be in hock to the bond markets. Ironically this will also become one of the first tests of Burnham's leadership. Will he appoint the obviously best candidate as Chancellor, or will he succumb to pressure from the media and market pundits to appoint someone more to their liking.

The Consequences of Tolerating the Far Right

 

As I have argued in previous posts, the rise in the far right is not a result of changes in people’s attitudes. In many ways over the last fifty years people have become more tolerant of minorities and less racist. What has changed is what is tolerated by the political elite.

There has always been a minority of people who, other things being equal, would support a party of the far right that promoted extreme socially conservative and authoritarian views and which encouraged social division. A much smaller minority of that minority are prepared to use violence. Those who went from house to house in Bellfast, pulling those who were not white on to the streets and burning their houses, did not have ‘legitimate concerns’. They were not fed up with lack of action on immigration, as a Times editorial absurdly suggested, because immigration has come right down. Belfast is not ‘flooded’ with asylum seekers, who comprise less than 1% of the population. Instead the rioters are the equivalent of football hooligans who wanted to start fights with supporters of the other side, or who used to glory in sectarian violence. People who used to be members of the UVA, the BNP, or before that the National Front. For some in unionist areas, non-whites are the new Catholics.

What has changed is that the leader of the political party with the most support in the UK incites this violence by calling for “pure cold rage.” What has changed is that every party on the political right is calling for large scale deportations including British citizens. That the right wing press, that once would have not been associated with such politicians or with any suggestions of inciting violence, now appear to show no such inhibitions. That the BBC actively attempts to attract viewers from a far right political party. That the departing chair of the media regulator describes Reform’s TV channel as covering the agenda of the majority. That the most widely used social media website should deliberately amplify calls by Moscow supported Tommy Robinson to protest against this “invader attack”, and a US Vice President who talks about a mass invasion of migrants. None of these actors care that they are inciting race riots, and some positively welcome it.

All these changes have eroded the social norms we used to have against racism, dehumanising minorities or exploiting tragic crimes for political ends. The situation has become a lot worse in the last few years in part because the fascist government in the US is actively promoting the UK far right, and because the UK Labour party foolishly thought they could diminish the popularity of the far right by parroting its language and policies.

The politicians of the far right will carry on competing amongst themselves about who can be the most barbaric. The right wing press is not going to change. Its wealthy owners have fully bought into the idea that encouraging social division is the best way of protecting their wealth. The countries that have actively encouraged the far right in the UK are not going to stop what has so far been a very successful strategy for them.

The only way we can stop this rapid decline into division and violence is for the political centre to stand up for the moral principles most people follow, and ensure the institutions that it can influence do the same. Condemning the rioters is easy, but this alone will achieve very little. Condemning the consequences without addressing the causes is bad politics and bad government.

Claims by those in the right wing media and by right wing politicians that immigrants are much more like;y to commit crimes need to be debunked by all politicians who are not on the populist right. The evidence is there, so why not use it. It is so easy for the media to give the impression that violent crime is unusually associated with immigrants or asylum seekers by publicising the cases that are and ignoring the much greater number that are not. [1] Media that does this needs to be condemned for doing so. Media and politicians that use individual crimes to push their political agenda should be condemned for doing so. Such actions exploit the victims of those crimes.

Draw a clear line between concerns about levels of immigration on the one hand (while also noting that immigration levels have come right down) and the dehumanisation of the immigrants who do come here on the other. In many ways what we see today can be traced back to May’s ‘hostile environment’: the immoral idea that treating badly immigrants who are here and trying to make a new life will discourage others from coming. Making it much more difficult formigrants to become UK citizens is part of that dehumanisation.

The absence of any of this kind of push back against the far right coming from politicians in government right now, and particularly from the Prime Minister, is part of our immediate problem. One of the jobs of a national leader is to be seen to lead when the social fabric is threatened by a minority intent on intimidation and violence. At the very least stop the government exclusively using social media companies that help incite riots. It needs to stop formulating policy as if immigrants or asylum seekers are always a problem.

Those working in the media have responsibility too. The broadcast media needs to stop calling race riots ‘immigration protests’. The media regulator needs to stop a news channel pushing a far right agenda and conspiracy nonsense. The broadcast media needs to be properly regulated, or it will become like our press, where those with extreme wealth can have extreme influence. What Musk has done to the most widely used social media platform is an excellent example of why those crying ‘freedom of speech’ to prevent regulation are talking nonsense. As I argued here (see also Geoff Mulgan here) free speech should not override the right not to be lied to. 

Ironically, what the political centre needs to do is to start reflecting the views of the majority of people in the country. It is not hard to imagine a UK where politicians in the centre were joining those on the left in setting out basic moral principles and calling out those that flouted them, and then to observe that a clear majority of people support these politicians of the centre and left. Farage’s call for pure cold rage was politically risky in that respect, and reflects a tendency of far right populists to go over the top and lose popular support as a result. (Whether they are more or less dangerous as a result is another question.) Very few voters approve of rioting, particularly rioting that involves picking on people based on the colour of their skin, and that includes people in Belfast.

A strategy that attacks rather than appeases right wing dehumanisation would be popular, and it could also be effective at discouraging support for the far right, just as it once used to be. The direct influence of the right wing press is not what it once was. Social media can be regulated. We got here not because this strategy of confronting attempts to divide and dehumanise failed, but because the UK’s political elite, first on the right and then in the centre, decided the strategy should be abandoned. Often they did this because it was in their own political interests to do so. In many past posts I have outlined when and how that transformation took place, and Daniel Trilling in his new book “If We Tolerate This” does something very similar. Just as the UK’s political elite started this, it can and has to end it.

[1] As the Migration Observatory notes, neither immigrants nor asylum seekers were associated with statistically significant changes in violent crime. As they note, any analysis of those who commit crimes requires looking at all potential causes, like age and labour market position. It is telling that those politicians who like to link crime with skin colour, religion or culture prefer to use individual cases rather than well researched evidence.

Trends in UK Inequality and Poverty

 

Popular discussion of inequality or poverty in the UK is often confused because there are many different measures of both. [1] Some facts are largely immune to measurement issues, like the fact that UK inequality and poverty increased significantly in the 1980s. Bourquin, Brewer and Wernham provide a good discussion, and this chart is taken from there.

So, for example, the ratio of the post-tax income of the top 10% compared to the bottom 10% rose substantially in the second half of the 1980s (helped by cuts to the top rate of tax), but has, if anything, fallen slightly since then.

In the past I have looked at the outer edges of the income distribution, and in particular the share of income going to the top 1%. That’s an income of around £200,000. Here is data from the World Inequality Database, which unlike earlier is pre-tax. For post-tax data see the IFS here. (For more on the characteristics of the 1%, see here.)

I’ve included data since WWII just to illustrate that the post-war period was marked by a steady and significant decline in the 1% share, which was reversed in the 1980s. The 1% share continued to rise in the 1990s and peaked around the time of the Global Financial Crisis, falling back slightly since then.

Wealth inequality shows a similar story, but there are notable differences. The decline in the 1% wealth share in the post-war period was very marked, reflecting in part very high inheritence taxes,. Wealth inequality rose in the 1980s, but more modestly than incomes, and has been growing slowly but steadily since. In addition over the last few decades the overall level of wealth to income has increased substantially.

Recent trends in the UK are very different to the US, where top incomes have exploded dramatically. For example the top 1% wealth share in the US has risen from a low of around 25% before 1980 to over 35% today. The (pre-tax) 1% income share in the US had also risen steadily since 1980, and is now approaching 20%. At the same time tax rates for the very very rich have fallen dramatically.

Why should we care about the very top of the income distribution? Sometimes it is suggested that very high incomes do everyone else no harm, so why worry about what a small percentage of individuals earn? This argument is in my view simply wrong, for two main reasons. First, the scale of inequality at the top is substantial. After tax, the top 1% earn around 9% of all incomes. To put it crudely, that means that by halving these top incomes we could increase everyone else’s income by over 4%, which is a lot. This is the same as saying that if the rise in the share of the 1% since the 1980s had not happened, everyone else would now be over 4% better off. Advocates for the wealthy would say that reducing top incomes would reduce the size of the overall pie, but we have no clear evidence for that.

Secondly, extreme levels of income and wealth tend to impact all of us through politics. We just need to look at the United States to see how this can completely distort the political process in a way that favours the rich compared to everyone else. One reason that post-tax inequality in the United States has risen much more than in the UK, particularly among the billionaire class, is precisely because the wealthiest have so much political power.

What about the other end of the income distribution? The first chart shows a sharp rise in poverty in the 1980s, and then a decline at the turn of the century thanks in part to decisions made by the last Labour government. Since then poverty has been relatively flat, but the chart doesn’t include recent years, and doesn’t include housing costs. Here the story is all about increasing costs in the last few years, as calculations from the Resolution Foundation clearly show.

From these charts it is clear that, while stagnation in real income growth is not pleasant, the so-called cost of living crisis can only really be called a crisis for those on low incomes. Note also that while pensioners are generally better off than workers, pensioners with the lowest incomes have also been hit hard. These numbers seem to strengthen the case for restricting any help following recent energy price hikes to those on low incomes. The number of children in poverty has been slowly increasing since the end of the last Labour government. A major cause of that was the two-child limit, which has finally been abolished by this Labour government.

This is a very brief discussion of broad trends, but I hope it illustrates one crucial point, which is that the extent of both inequality and poverty depend crucially on political decisions about taxes and benefits. To a considerable extent levels of inequality and poverty are what societies choose them to be. But in democracies inequality and poverty are rarely major election issues, so perhaps it is more accurate to say that levels of poverty and inequality are what political elites and their influencers want them to be.  

[1] The best source of discussion of all kinds of inequality, from income and wealth to geographic, housing, education, health and so on, is the Deaton review by the IFS. This much shorter piece in the FT by Toby Nangle is also interesting.

Immigration numbers and the media

 

According to YouGov, ‘Immigration and Asylum’ was the second most important issue facing the country in May, just behind the economy. According to IPSOS immigration/immigrants was the most important issue, rising well above the economy. Concern about immigration began rising at about the same time as net immigration into the UK started increasing dramatically, to nearly a million a year in 2023. Yet net immigration fell as rapidly as it rose, and at the end of 2025 was at levels typical of the period before the post-pandemic increase.

So why is public concern about immigration still so high? The straightforward reason is that most of the public don’t know that net immigration has fallen dramatically. According to recent polling conducted on behalf of British Future and the Policy Institute at Kings College London, only 16% of people think net immigration fell over the last year, while around half thought it had increased.

It shouldn’t be surprising that most people have little idea that net immigration has been falling rapidly over the last two years. Most people don’t follow data like this, and unlike issues like health or the cost of living they often don’t have their own or friends/relations experiences to fall back on. [1] When voters are asked about important local issues, immigration falls sharply down the list of issues that matter. They therefore rely to a much greater extent on what they pick up from traditional or social media.

Of course the nature of the concern that some people have about the issue is very real. It could be xenophobia, or just a dislike of change, or a perceived link to other issues like employment, wages, housing or access to public services. But whether immigration is intensifying those concerns does depend on the numbers involved, so it does matter that voters think immigration is increasing when in reality it is not.

What most voters do notice is what issues are talked about on regular news bulletins. If those news programmes involve politicians from Reform, then they will invariably talk about immigration or asylum because that is their issue. Because they want to sustain a concern about the issue, Reform politicians will not be telling the public that numbers have come right down. So voters imagine immigration numbers are still high and rising, because politicians are still talking as if they are.

We can blame government politicians for not emphasising the recent data enough (see below). But voter’s understanding of basic social or economic facts should not have to rely on the communication skills of politicians. It should be the media’s job to keep people informed. For the BBC, informing the public is part of their mission. In the case of immigration numbers it appears as if the media is failing to achieve this mission. As Chris Dillow reminds us, immigration numbers is not the only politically sensitive area where the public is seriously misinformed, and typically the misinformation favours the political right.

A major reason for this is that in some parts of the media, those parts where news is selected to become propaganda, this failure is entirely intentional. The right wing press, GB news and large parts of social media will describe high immigration numbers in terms of ‘floods’ and ‘invasions’, but will give far less publicity to falling immigration numbers. In this sense they act just like the right wing populist politicians they support.

However, for the broadcast media that likes to think of itself as impartial, this disconnect between reality and what voters perceive, for an issue which is politically crucial, should be keeping those who work in it awake at night. It doesn’t, of course. (If I’m wrong about this, let me know!) We often take it for granted that journalists should above all else want to get the facts across, particularly when those facts are not well understood or are simply not recognised, but increasingly In the UK, as in the US, there is little incentive for them to do so.

The obvious response from those in the media is that they do give immigration numbers publicity when this data comes out, and what else can they do? The answer is a lot. When journalists interact with politicians on a day to day basis, particularly those who benefit from popular misunderstandings, they can make a particular point of mentioning the data, like the latest immigration numbers. A regular question for right wing populist politicians is why they are not welcoming the fact that immigration numbers have come right down. The same can be done in the commentary that senior political journalists in the broadcast media regularly give in interpreting political news.

As I suggested earlier, the media doesn’t do this because they don’t have sufficient incentives to do so. The media worries about what politicians think, and as a result is obsessed by balance, but most politicians are more interested in favourable coverage than the facts. In the UK the propaganda news media has an outsize influence on the broadcast media. Finally the UK regulator, Ofcom, is hopeless.

Public misunderstanding of facts in highly sensitive political areas will only be corrected when the media has an incentive to do what it can to correct them. That incentive has to come from politicians and the media regulator, because it is not going to come from anywhere else. In assessing the health of a country’s collective media, the extent of public misunderstanding on key issues should be a critical piece of evidence. Media bosses should be held to account for this, and asked constantly what they are doing to correct it.

Because these public misunderstandings typically favour the political right, and often come from the section of the media that supports the political right, then we cannot expect right wing politicians to apply this kind of pressure. Indeed the political right would be happy to see little or no media regulation. Pressure of the kind I am suggesting has to come from the political centre and left.

Our current Labour government has failed dismally here for many reasons. First, as I noted some time ago, it seems to have little interest in improving media regulation, and has left those imparting a right wing bias to the BBC and media regulation in place. Second, it has enacted some policies designed to reduce immigration numbers that will cause serious economic damage, like helping to cripple one of the UK’s most successful export industries. Third, and most alarmingly, it sometimes adds to public misunderstanding by repeating false narratives like immigration is adding to pressure on public services. In this respect, a government that has seen immigration fall drastically and yet is getting no credit for doing so has only themselves to blame.

[1] I would argue that the term ‘the economy’ can have a similar quality to it.

New ideas from Labour on economic policy

 

It may be a coincidence, but the possibility of fresh leadership seems to have inspired a couple of papers published by Labour groups on how to reform the UK economy. In reality their appearance is probably more a testament to at least the perception of the lack of major reform coming from the current Labour government. Ben Zaranko has already discussed both in the Observer, but I think what I write here is complementary. (Unlike Ben I won’t be discussing ‘Manchesterism’ for reasons well set out by Joshi Herrmann here.)

The paper from the “Labour Growth Group” is written by Mark McVitie with Chris Curtis MP. Its overall theme can be summed up by the following quotation:

“Britain has become an economy where position too often pays better than action and contribution. We call this the extraction economy: a settlement in which holding scarce assets, protected licences, legal leverage, regulatory position or the power to shape and navigate broken systems can pay better than working, building, investing, caring, competing or taking productive risk.”

This is a call to prioritise socially productive activity over rent seeking that will be familiar to many, including economists. The paper argues that to achieve this requires a shift “from a distributive state to a capable one: the democratic choices of the people delivered by a state that can choose, build, enforce, reshape markets.” The paper argues that the UK state contains the power to act capably, and implies that the reasons it doesn’t lie in political attitudes.

The paper does have two important, although familiar, suggestions as to how to get the state to be more capable and less managerial. The first is to give the Prime Minister more resources, by building a Department for the Prime Minister. The second is to devolve power regionally, and in particular financial power, which this government has begun to do. (If Manchesterism is anything it is this.) While I strongly agree with the second proposal, I was not convinced either would in themselves necessarily achieve a more capable state. The paper says that centralisation means that “organised interests need capture fewer decision points”, but equally organised interests may find it easier to dominate local and less powerful politicians, or even play one region off against another. That criticism does not imply that financial devolution is wrong, but that it is right for different reasons.

More generally, if I ask myself why this Labour government has been such a disappointment over the last two years, I’m not sure I would answer that at an institutional rather than personal level. Its major mistake, it seems to me, has been a wish not to upset most social and political groups, leading to an inability to make key reforms. This helps produce an excessive deference to the status quo. It is the mindset of an opposition facing an unpopular government, not a government determined to pursue its own vision. (Ironically one group the government has felt free to offend have been its core supporters, which has led to its current downfall.) To quote from the paper: “The British state increasingly … treats conflict between objectives as an administrative problem to be managed, rather than a political choice to be made. The consequence is paralysis, not balance.” This seems like a criticism of political leadership rather than institutional structure.

Of course there are limits on what it is possible for Labour insiders to say publicly in this respect. However on one important point in the paper I clearly disagree. To quote: “The tax burden as a whole is unsustainably high, in time the economic benefit of this programme should provide scope to reduce it, but for the time being we believe the burden must first shift from the payslip.”

The overall tax burden is historically high, but this is true in most countries and the main reason for it is the same: a growing demand from an ageing and wealthier population for health services. That cannot be wished away. What is not historically high and what is certainly not unsustainably high, is taxes coming from the payslip. As the IFS shows, UK tax revenue is lower than in most Western European countries, and in particular the UK raises far less from employees' social security contributions than other countries. While the overall tax burden has been increasing, since the early 1980s taxes in median earnings have been falling almost steadily (see this post and the chart from the Resolution Foundation reproduced there).

The second paper is by Louise Haigh. There are clear commonalities with the Growth Group paper. For example “we must look to reduce regulatory barriers, especially those that are holding back new and innovative businesses wishing to scale up.” Labour’s reforms of the planning system are praised by both papers, and as Ben Zaranko points out this parallels US arguments around “abundance”.

While the Growth Group paper sees the central problem as vested interests around rent seeking holding back growth, Haigh focuses on short-termism.

“A central weakness in the UK’s economic model is the systematic undervaluation of what might be termed “preventative” investment – spending that reduces future fiscal pressures while raising long-term growth. Our institutions, appraisal frameworks, and political incentives are poorly configured to recognise these benefits, tending instead to favour interventions with immediate, easily measurable returns.”

But isn’t it the high cost of borrowing that is currently holding back investment?

“It is therefore possible for two things to be true at once: that the current institutional framework is ill-suited to supporting long-term growth, and that the immediate constraint on government action is the cost of borrowing in financial markets. A credible reform agenda must address both – improving the framework over time while demonstrating, in the near term, that public investment will strengthen, rather than weaken, fiscal sustainability.”

I agree with Haigh about the importance of public investment. Public investment is often complimentary to private investment, so increasing the former should help raise the latter. 

Where I would have a different view is on the details of how you achieve that. The key fiscal rule, the golden rule, already excludes public investment, and I have written chapter and verse on why it is essential that it should. The other fiscal rule (falling debt to GDP) doesn’t, but I have also long argued that this second fiscal rule is not fit for purpose and should be simply abolished. Once this is done, public investment decisions would be unconstrained by fiscal rules, which is a much more straightforward way of achieving the goal that Haigh wants. Typically when she became Chancellor Reeves tinkered with the fiscal rules in a way that wasn’t very controversial, rather than making more radical but logical changes.

In contrast, the paper’s suggestion of extending the time horizon of these rules from five to ten years, while allowing more of the benefits of public investment to become apparent, makes targets too easy to game by governments, leading to the rules losing credibility. Five years is about right, because in OBR forecasts the economy pretty well always returns to trend within five years, yet it is also sufficiently close that it is hard to game (unless you don't believe you will win an upcoming election!). I also don’t think taking away responsibility for growth from the Treasury works, as I discussed in the context of the Kerslake review here. It is perfectly possible for a Chancellor to override traditional Treasury concerns, as Gordon Brown showed.

What I think it is also important to acknowledge, and which too many within Labour including these authors avoid acknowledging, is that the main reason our public services are weaker than in other Western European countries is not because of our fiscal rules or Treasury attitudes or vested interests but simply because we put less resources into them by paying less tax. Take the health service for example. The only hope we have of stemming the growing demand for health services is to focus more on prevention, which however it is classified is a form of investment. This is an age old message pushed by expert after expert. But it doesn't happen at scale, and will not happen, as long as the resources going into NHS front line services are tightly squeezed.  

Where I do agree with Haigh is that decisions about selling the Bank of England’s large quantity of public debt (the result of earlier Quantitative Easing) should not be in the hands of the Bank. When short term interest rates are free to move, the Bank’s debt sales have fiscal consequences rather than implications for inflation and therefore should be a Treasury concern. Making it so would not compromise central bank independence in any meaningful way.

Given that the Bank is not only making government borrowing more expensive by selling its debt now, but also by selling the debt when it’s relatively cheap making a capital loss, unlike other central banks, it is surprising that the Chancellor has not done anything about this. It emphasises the point I made earlier that the government is unduly cautious about doing anything that might upset the status quo. When so many voters feel that nothing works in the UK, what you don’t need is a government that only offers small change.

Why Labour's current disarray is ultimately the consequence of Osborne’s austerity

 

I want to expand on a footnote to last week’s post. As I said there, we now have clear evidence that austerity from 2010 onwards helped fuel right wing populism, Brexit and Farage. However, that post argued that right wing populism would have emerged anyway, because its fundamental cause was a trend towards ending elite taboos on the right against appealing to xenophobic and racist voters which we see across the world. So austerity just helped populism arrive more quickly and, with Brexit, more dramatically.

In contrast I do think a lot of the problems we see in the UK Labour party today stem from Osborne's successful devastation of public services, and it is less clear they would have happened anyway. A Conservative cutting public services to numbers way below what the public were comfortable with should have been a gift to Labour of course. So I think the story of how it turned out otherwise is worth spelling out.

It is easy to forget how almost universal the belief was in the UK media during the austerity years that reducing the budget deficit had to be the major macroeconomic priority. Basic macroeconomics, understood since Keynes, said that when interest rates were stuck at their lower bound cutting the deficit would damage a recovery. This was ignored, despite it being in the worst recession since WWII. We now know, from empirical work at the IMF, that trying to cut the deficit in this situation not only prolonged the recession but in all likelihood made the public finances worse in the medium term as well!     

As few now defend Osborne’s policy today, it is easy to forget how much it seemed to be common sense to the media and large parts of the electorate at the time. I invented the term ‘mediamacro’ to describe this. In contrast a majority of academic economists opposed austerity as it began, unsurprisingly given it violated what we all taught, and this majority grew steadily over the next few years as the damage became clear and the intellectual arguments for austerity collapsed, but none of that made much impression on the media.

The result was that Labour in opposition found their arguments against Osborne’s policy were getting nowhere, and so they were gradually discarded. [1] Despite UK workers facing a cost of living crisis at least as bad if not worse than over the last few years, the Conservatives won the 2015 election, and the media’s promotion of austerity played a key part in that. The reaction to this among many prominent Labour figures was to almost completely accept the case for Osborne’s austerity. Ironically, just when public opinion was finally beginning to turn against what Osborne had been doing, it looked as if Labour’s senior politicians were heading in the wrong direction.

I thought at the time and still think this is the essential background to understanding the election of Jeremy Corbyn as leader in 2015. A majority of Labour members hated austerity for good reason, and were dismayed at seeing their party leaders be equivocal at best. Corbyn was the only one of the four candidates who clearly opposed austerity, and as a result he won overwhelmingly. It is silly to blame this result on ‘entryism’, although that is less true of his re-election in 2016.

So I think it is fair to say that it was austerity, and the failure of Labour to dent the media consensus that austerity was necessary, that led to the four years in which the left led the Labour party. Of course that doesn’t excuse the Labour leadership that came before him for their appeasement of austerity, but I hope it makes it a little more understandable. Equally it is unconvincing to suggest that most of this pre-Corbyn leadership actually wanted a smaller state, after they spent years in government doing the opposite.

In opposition Labour under Corbyn and Shadow Chancellor John McDonnell did make good on the promise of ruling out a repeat of 2010 austerity. Although McDonnell accepted (rightly in my view) the need for a fiscal rule, these would not apply when interest rates were stuck at their lower bound, which they had been since 2009. The media at the time called this a ‘loophole', of course, but something like it is now standard in most UK fiscal rules adopted in recent years. In the recession that came with the pandemic Sunak made no attempt to pretend that the budget deficit was the priority, and instead enacted a (probably overgenerous) fiscal stimulus package, which was the opposite of the policy advocated by Osborne in 2009.

It also became clear, pretty quickly after Corbyn’s election, that there were those on the right of the Labour party that would never accept a party led from the left, and who were prepared to see a Conservative government as a price worth paying for taking control of the Labour party away from the left. They had expected this to happen in 2017, and were rather shocked when it didn’t, but they organised with the help of the media to ensure it happened in 2019.

That is not to suggest that this right wing faction was responsible for Corbyn’s 2019 defeat. Actual and potential Labour voters were overwhelmingly against Brexit, and as it became clear from 2016 to 2019 what Brexit under the Conservatives would entail, this opposition grew more impassioned. Corbyn was slow to respond to this, which neither pleased Remainers or (when he finally did) Leavers. But the reality probably was that there was very little Corbyn could have done that would have prevented Johnson winning in 2019.

Defeat, together with the anti-Brexit views of most Labour party members, meant that the left were unlikely to win the contest for his successor in 2020. Morgan McSweeney from Labour’s right found their ideal candidate in Keir Starmer. He was a relatively new MP without a public record of clear policy positions, and he promised to unify the party with a platform that was pretty left wing.

Whether Starmer always intended to renege on this platform, or whether it was McSweeney’s influence that persuaded him to do so, we will probably never know, although plenty of people will tell you they do. In an important sense it doesn’t matter. Either Starmer was always part of the right wing faction that intended to bring Corbyn down, or he was politically naive and therefore easily persuaded by the man who got him elected to allow a purge of the left [2] once he had won, but the result was the same. Neither alternative reflects well on Starmer.

Purging the left didn’t have an immediate electoral cost while the Conservatives were in power, as it was the Conservatives who badly lost the election in 2024 rather than Labour winning a great victory. Labour won with just 34% of the vote, having been over 40% in the polls a month before. However, once in government the influence of McSweeney, and the political weakness of Starmer, began to have serious costs. Just as the far right faction had had contempt for the left during the Corbyn years, when in power they seemed to have a similar indifference to voters with socially liberal views. In McSweeney’s case this reflected a Blue Labour ideology, which combined modestly left wing economic policies with pretty socially conservative policies on asylum and immigration.

This position was the worst of all worlds for the Labour government to take. Copying Reform on immigration and asylum just legitimised and reinforced Reform’s appeal, while at the same time alienating much of Labour’s core vote. Labour in government has lost voters on both sides, although more to the left than the right. Disastrous Council election results inevitably followed, as many of us said they would. (I initially made this point a year ago.) It is true that Starmer has made plenty of other mistakes, but it is far from clear that these mistakes are similar in magnitude to those made by Johnson and Truss. It is best to ignore the preoccupations of the media here. What gives the media licence to pretend otherwise is Labour’s terrible poll position, which reflects losing votes to their left as well as to the right.

In this respect Labour and Starmer’s current precarious position is a direct result of being led by the right wing faction that wanted Corbyn out at all costs, a faction that gained control because of Corbyn’s victory in 2015, a victory which in turn owed a great deal to Osborne’s austerity policy and the Labour leadership’s powerlessness to strongly oppose it. What we are seeing today, therefore, is a direct consequence of that austerity policy and the support it received in the media. Furthermore, it is not obvious how all this would have happened without Osborne’s austerity and the media’s promotion of it.

Of course setting this out does not imply that any of it was unavoidable. Labour could have fought austerity in a more knowledgeable way (see footnote 1.) The media should have been more interested in what academics said and paid less attention to central bankers who had axes to grind and market analysts who had a vested interest in austerity [3]. Lexit was always a dumb idea. Those on Labour’s right who wanted Johnson rather than Corbyn in 2019 gave us a version of Brexit that has produced the economic stagnation that limits what Starmer can do today. While some Labour voters are socially conservative, it was always obvious the majority are not and would not remain passive as Labour trotted out Reform cliches and lies. Yet historical analysis involves recognising actors as they are rather than how you would like them to be. In this respect it is ironic that Osborne’s austerity not only screwed up the economy and public services until this day, but it has also inflicted severe political damage on the Labour party.

[1] If I wanted to be critical, I would say that the weakness of Labour opposition to austerity owes something to a mistake made in government, by a new Chancellor preoccupied by rescuing the banks and strongly influenced by the Treasury’s fear of rising budget deficits. The policy message then should have involved clear priorities: first deal with getting the economy completely out of the deepest recession since WWII, and only once the recovery was almost complete and interest rates were rising to start dealing with whatever excessive budget deficit remained.

But Labour’s plans to reduce the deficit when in government meant its message in opposition, faced with a Conservative government determined to cut spending even when the economic recovery never came, was weak. As growth stagnated from 2010 to 2012, instead of saying this was because the government was focused on the wrong problem they instead just said it was going too fast. Instead of confronting with basic Keynesian economic a media convinced that deficit reduction was necessary, Labour’s message seemed tame and failed to convince many.

However, so total was the media’s conviction that Osborne was right that I doubt that even this superior messaging in government and then opposition would have made that much of a difference to Labour’s fortunes at the time.

[2] Of course there have always been battles between left and right within Labour. However figures like Corbyn were tolerated by Blair, but not by Starmer. In reality there is a significant proportion of voters who are socially liberal and economically left wing, and if they don’t feel represented by the Labour party then they are easily lost to a dynamic party that does embody their views.

[3] Austerity killed the recovery meaning that short term interest rates would be stuck at their lower bound for a long time, meaning longer term interest rates fell and bond prises rose. As Toby Nangle points out the bond markets cheered, because rising gilt prices produce good returns. Taking macroeconomic advice from bond market traders is like taking advice on how to deal with pandemics from undertakers.