October Budget 6: Thanks to Truss, bond market scare stories are back

 

In truth they never went away, but after Truss there is a danger that they will be taken more seriously. The FT recently published a classic of its kind, entitled “Gilt investors urge Reeves to keep investment ambitions in check”. The subheading read “Markets on edge ahead of overhaul of fiscal rules that could result in tens of billions of pounds of extra borrowing capacity”. Sounds scary, but worse is to come.

The article warns that Reeves may “bump up against tight constraints in the bond market as investors warn they have a limited appetite for fresh UK debt”. One trader suggested that anything more than £10bn to £20bn in additional borrowing could “push gilts over the edge”. The language of ‘constraints’, ’on edge’ or ‘over the edge’, and ’limited appetite’ all suggest the potential of a crisis where the government can no longer sell its debt.

As a result of this and other similar articles, I have seen plenty of pieces from political commentators warning that the budget might ‘spook the bond market’. This suggestion, along with the accompanying language, is complete and utter nonsense. The idea that if Reeves wanted to borrow an extra £30 billion, say, the markets would refuse to lend that to the UK government is just ludicrous. Reeves will not bump up against any constraints from the bond market for anything she is realistically likely to do.

What is possible is that a lot of extra borrowing might lead lenders to the UK government requiring a better interest rate. But this has little to do with supply and demand for UK government debt, and instead reflects expectations about what the Bank of England might do in the future (‘arbitrage’). If additional borrowing is associated with additional aggregate demand for UK goods, this will increase inflationary pressure, which in turn will mean the Bank keeps interest rates higher than they might otherwise have been. I discussed the mechanism for this in more detail here. At the end if this post I briefly discuss what the inflationary impact of additional public investment might be. 

This is exactly what happened initially with the Truss fiscal event. With inflation high and rising, the Bank of England were raising interest rates because they thought that strong labour demand coupled with weak supply could make the impact of the energy and commodity price shock more persistent. A fiscal event that cut taxes would only add to aggregate demand, meaning that the Bank would have to raise short term interest even further. If short term interest rates are expected to rise, so will the longer term interest rates in the market for government debt. Markets didn’t stop buying government debt, but they made it clear they wanted a higher interest rate on this debt because short term interest rates were expected to be higher as a result of the fiscal event.

With Truss, two factors turned normal market behaviour into a crisis. The first was peculiar to what Truss was doing. By announcing tax cuts without an accompanying OBR forecast, and with no clear indication of whether these would be followed at a later date by spending cuts (and if so, by how much and how credible were such cuts with public services already in crisis), accompanied with suggestions more tax cuts were to come and maybe Truss and others thought these tax cuts would ‘pay for themselves’ by boosting growth (which most people in the markets knew was false), the overall direction of fiscal policy suddenly became much more uncertain. [1]

By throwing a well established fiscal framework out of the window, Truss greatly increased the amount of uncertainty in the markets. If the return on an asset suddenly becomes much more uncertain, then other things being equal most would feel less inclined to buy that asset. The demand for Sterling assets fell, which is why Sterling depreciated when an appreciation would normally have been expected.

This increase in uncertainty led to interest rates in the market for government debt rising further still. That produced a second peculiar event, which was that pension funds suddenly had to sell a lot of their government debt (more details here). With few buyers and many sellers, the market for government debt became too thin for arbitrage to work, leading the Bank of England to step in as buyer of last resort (just as they did during the early stages of the pandemic).

These two factors, Truss’s departure from the OBR monitored method of fiscal policy making and the pension fund crisis that caused, were what turned what might have been a normal and relatively modest upward movement in interest rates into a crisis. Nothing Rachel Reeves will do in her budget is comparable with this. She has not sacked the most senior Treasury civil servant, she has not dispensed with the services of the OBR, and it is the OBR not Reeves that is making the reasonable case that additional public investment will almost pay for itself.

Which makes all talk of markets going ‘over the edge’ if Reeves increases borrowing to fund that investment just ludicrous. So why do we see that kind of nonsense written in otherwise sensible newspapers like the FT, alongside similar scaremongering from more predictable sources. A lot is simply political. Do you remember all the articles warning that the Truss fiscal event would spook the bond markets in the weeks before it happened? I don't.

Scaremongering works because of an absence of understanding, with most people having little idea of how financial markets work. Two things follow. First, articles warning of a crisis will be read rather than dismissed, which is good for the journalists that write them. Second, the words of market participants are given far too much weight, because they are seen as people who do know how markets work. That means all too often that financial markets are treated like a capricious god, and City economists like high priests. 

The reality is that it is not hard for any journalist to find market participants willing to say that extra borrowing will lead to a crisis, but the market also contains analysts who are much more sensible. As an example here is a piece by Will Dunn, which first quotes a City economist warning of a buyers strike if borrowing rises, but then quotes another giving a much more reasonable analysis along the lines outlined above.

The lesson is to ignore any article or any City economist that predicts a bond market crisis as a result of any normal budget where borrowing might be higher than previously planned. Higher public investment financed by additional borrowing might add to inflationary pressures, which might mean the Bank cuts interest rates more slowly than it otherwise might have done leading to moderately higher interest rates on government debt, but that ain’t no crisis and in my view is a price worth paying for much needed investment and improving economic growth.

But will additional public investment add to inflationary pressure? I ask because I read this, where Dan Davies discusses a brief interchange between himself and NIESR head Jagjit Chadha. Jagjit suggests that because public investment supports future supply, and because inflation setters are forward looking, any short term pressure on aggregate demand might not find its way into inflation.

I don’t buy this argument, even on its own terms. Yes, public investment will directly or indirectly improve the future capacity of the economy to supply goods and services, but there is no reason to think that aggregate demand will not expand to fill that capacity of its own accord. For example, if public investment helps improve future productivity, wages are likely to rise in line with that as they normally do, leading to higher consumption and aggregate demand.

What the Treasury can do is be aware of any inflationary dangers in choosing what investment to prioritise (as well as ensuring that projects are worthwhile in standard cost benefit terms). For example, as I have mentioned before, projects that involve buying stuff from abroad (e.g. MRI scanners) put less pressure on aggregate demand than projects that are entirely home produced. The US experience suggests it is possible to substantially increase investment without creating significant persistent inflationary pressure, and with sensible planning it may be possible to do the same in the UK. 

[1] If these tax cuts were quickly followed by credible spending cuts, the overall impact on aggregate demand would be negative, because some of the tax cuts would be saved. This would mean the Bank would lower, not increase, interest rates. In contrast, if those in charge really did think these tax rises would pay for themselves, and intended to do more of them, then the Bank would have to increase interest rates by a lot. 

Why are the Conservatives ignoring the median voter?

If the candidates for the Tory leadership sound much like ministers in the last year of the Conservative government, it’s because the leadership campaign started well before Sunak lost the election. But they lost that election very badly. To many it seems odd that the leadership contenders, at least publicly, appear in complete denial about this loss, and are carrying on as if it hadn’t happened. Given the nature of the leadership election, that puzzle quickly becomes why Conservative party members appear to be in disbelief about why they lost so badly.

It is easy to say that this is what happens when a party loses after being in government for so long. Many compare the current contest to what happened after Callaghan was defeated in 1979, or Major in 1997, or Corbyn’s victory in 2015. I think these comparisons are not very helpful. Let me start with the comparison that tells us very little. Corbyn’s victory in 2015 was five years after the previous Labour government, and it happened not because the membership were in denial about why they lost power in 2010 but because many shadow ministers were in denial about the appeal of austerity.

You could argue that Labour lost in 2010 because of its large budget deficit and their failure to prioritise reducing that deficit. [1] It is certainly true that the Conservative victory in 2015 owed a lot to the almost total acceptance by the media that reducing the deficit was more important than declining living standards and a pathetic recovery from recession. Perhaps as a result, the consensus among shadow ministers in 2015 appeared to be that Labour had to accept even more of the austerity agenda than they already had.

But that consensus was wrong, and the instincts of Labour members to want a much stronger opposition to austerity was correct. As I argued at thetime, the appeal of austerity was always going to be time limited, and Labour did well in 2017 partly because it wanted a larger rather than smaller state. The reasons for Corbyn’s failure in 2019 were not the reasons why he won in 2015.

A potentially more relevant comparison is with the victory of Ed Miliband after 2010. Yet one of the big mistakes Miliband made was not to defend the Labour government’s record, which allowed the Coalition to get away with ridiculous ideas that the country had been on the brink of a financial crisis in 2010 and that the recession was all Labour’s fault.

Is Labour’s shift to the left after its 1979 defeat a better comparison? Just as Labour then was deeply split between left and centre, you could say the Conservatives are split between the right and a One Nation centre. But whereas the split within Labour in 1979 onwards was both very evident and extended to the membership, if the Conservatives are split the centre is both remarkably quiet and appears largely absent from the membership.

In addition, 1979 is very different from 2024 in terms of the government the opposition is facing. It became quickly clear that Thatcher represented a sea change in ideology on the right, while Starmer’s victory was based on ensuring that the policy differences between Labour and the Conservatives were both minimal and minor. Starmer might be bolder in government, but the extent of that is far from clear at the moment.

Such comparisons also fail because of the unique feature of both the last election and the current contest, and that is the presence of a strong party further to the right of the Conservatives. Reform showed in 2024 that it was able and willing to win large numbers of votes at a General Election at the cost of seats lost by the Conservatives.

For party members it is convenient to believe that Reform was why they lost so badly, in part because many of those members have considerable sympathy for Reform’s agenda and would quite like Farage as part of the party. Little that they read in the right wing press would lead them to ask more fundamental questions about why their party became so unpopular. In addition, the victor of the 2024 election hardly presented a radically different policy platform to the last government, which can be read (if you are predisposed to) as suggesting that there wasn’t that much wrong with what the last government was doing.

However it is too simple to suggest that the nature of the leadership contest would be very different if members didn’t have the final say, for two reasons. Many Conservative MPs appear to believe that Reform poses an existential threat to the Conservative party ever returning to government. The idea that a far right party could dominate a more centre right party is not that fanciful if you look at what is happening in many other countries. Even dominance is not necessary to prevent the Conservatives winning if Reform continues to split the right wing vote.

Of course such comparisons need qualifying for various reasons. Trump dominates the Republican party because he took over the leadership of that party, and so far Conservative MPs have been sensible enough not to let Farage repeat the same trick in the UK. The first past the post system in the UK is also pretty effective at preventing a third party replacing the big two.

Nevertheless Conservative MPs may feel that they have to at least match the Reform offering on immigration and other socially conservative issues, so voters where these issues are a priority will go back to voting Tory once memories of the failures of the last government fade away. If the Labour government becomes unpopular enough, then the Conservatives can persuade potential Reform voters that they need to vote Conservative to get Labour out. This might work if enough disillusioned Labour voters switch to the Greens or LibDems.

Even on its own terms, the strategy of following rather than confronting Reform has significant problems. Reform will always be able to outflank the Conservatives on immigration and other issues because they can suggest policies that are even more fanciful, which can survive because the party is subject to less media scrutiny than the Conservatives. (They also survive because media scrutiny can be pretty poor - see Rwanda - and the political right is increasingly able to ignore evidence - see climate change.)

In addition, Reform has Farage (Reform is Farage!), and a strong charismatic leader has particular appeal to socially conservative voters. None of the current Conservative candidates can match Farage in this respect. In addition, some analysis suggests that among all potential Tory voters, those voting Reform are more difficult to win over than those who switched to Labour, the LibDems or who did not vote at all. Finally the emphasis given to very socially conservative policies may alienate some traditional Blue Wall Tories.

An equally significant problem is that this strategy ignores economic policy. Where the current Conservative party really appears to be in denial is its faith in the appeal of low taxes, its silence on how to improve public services, and the failures of Thatcher’s privatisation policy. It is the unpopularity of these policies that require the Conservatives to emphasise issues like immigration in the first place, which in turn gives credibility to the likes of Farage. Some Conservative MPs must understand this, but the wishes of the right wing press, party donors and members prevent those MPs even suggesting a move to the centre on economic issues.

As a result basic questions remain unanswered, or their answers can only be voiced in private. How can you be a tax cutting party when the health service continues to require a larger share of total national resources (GDP) over time? The only answer the Conservatives have is for the NHS to become a bare bones, inferior service which the majority of the middle class opts out of, but that answer is electoral suicide. How can you insist on cutting red tape when that leads to tragedies like Grenfell and a water industry exploiting both its customers and the environment. The only answer the Conservatives have is that these are acceptable costs in order to free the burden on business, but again saying this publicly would be electoral suicide. They have no answer to how can you cut immigration without damaging industry, universities or the public services, or how ‘taking back control’ has led to less international influence and power (as well as economic harm) And most fundamentally of all, how did fourteen years of a policy supposedly designed to help business thrive lead to the worst period of UK economic growth since WWII?

The best comparison for the Conservative party today is what happened after Major’s defeat in 1997. It also failed to ask whether some of its Thatcherite/neoliberal economic policies might have been responsible for its defeat, and relied on issues like immigration to attack Labour. That strategy failed in two general elections, and eventually Shadow Chancellor Osborne was forced to move to the centre by accepting Labour’s public spending levels. They only just won in 2010, but even that was largely down to luck (Labour being blamed for the Global Financial Crisis) and disastrous opportunism (convincing both the media and voters that reducing the budget deficit should become the country’s macroeconomic priority).

In 2024 the state of the public services is far worse than in 1997. In addition, the privatisation of rail companies is ending and the privatised water industry is a national scandal. Simple median voting models imply that being so far to the right on both social and economic issues compared to the views of the average voter should condemn the party to perpetual opposition. Does denial by the Conservative party of the unpopularity of its economic policies condemn it to indefinite opposition?

That ignores a key lesson of 2024, which is that the popularity and competence of the government matters more than the policies of the opposition in influencing votes. It ignores that Labour too need to worry about losing votes on both flanks thanks to the success of the Greens in 2024. It ignores the lessons of 2010 and 2015, which is how easily the wider media can be manipulated. For these reasons, even a party in denial about the unpopularity of its policies can win elections. For this reason it will take more than one election defeat for any party leader to challenge the views of party members, financial donors or press barons, and attempt to move the Conservative party away from the ideological cul-de-sac it now occupies.

[1] I have argued the opposite: that the Treasury persuading Darling to put deficit reduction on a par with recession recovery played into Conservative hands.

October Budget 5. The UK’s Fiscal rules: one good and one bad

 

On 30th October Rachel Reeves will be setting out her first budget, rather than responding to someone else’s decisions. She will be leading the public discussion, not following the narrative set by another. That will be obvious in terms of tax, because she will be raising taxes rather than pretending to permanently cut them. But it should also be true for the fiscal rules that she commits the government to follow.

In his first budget of 1997, Gordon Brown set out his own fiscal rules. They were very different from anything followed by his predecessor, and they were innovative at the time. They lasted for ten years, derailed only by a global crisis and the worst recession since WWII. The forthcoming October budget is also a chance for Rachel Reeves to establish her own fiscal rules that are better and last much longer than those of her predecessors. [1]

Last week’s discussion of why we have fiscal rules gives us three basic properties that good fiscal rules should have:

1. They should discourage politicians from using deficit finance (paying for higher spending or lower taxes by borrowing or creating reserves (money)) simply to avoid the unpopularity of raising taxes or cutting spending, rather than for any good economic reason.
   
   

2. Conversely they should not prevent deficit finance when this makes sense in economic terms. For example there are good reasons why fluctuations in public investment should be financed by borrowing, and overwhelming reasons why a deficit financed fiscal stimulus should be used when an economy is at risk from, in, or recovering from a recession.
   
   

3. Fiscal rules should focus on underlying trends, rather than short or medium term fluctuations in spending (wars, pandemics, greening the economy) that have no strong implications for sustainability.
   

Fiscal rules that do not have these properties are bad rules, and it is better to have no fiscal rules than bad fiscal rules.

One of the fiscal rules that Reeves says she will follow largely has these properties, and one clearly does not. The rule that does is sometimes called the golden rule, and it states that in the medium term day to day public spending (all spending except investment) should be equal to total taxes. Specifically this involves a rolling five year ahead target for the current budget deficit (public spending excluding public investment minus taxes) of zero. However, as governments since Cameron/Osborne have acknowledged, and as first proposed in Portes and Wren-Lewis, this target has to be conditional on the economy not being close to, in or recovering from a recession. [2]

The conditional golden rule achieves property (1). It achieves (2) because it doesn’t apply during a recession, and the current balance excludes public investment. A rolling five year ahead target helps achieve (3), because forecasts five years ahead almost always involve the economy being on its medium term path. It is often suggested that having a rolling target rather than a target for a fixed date is bad because it ‘lets politicians off the hook’. This is false, particularly if forecasts are done by an independent body like the OBR. In contrast having a target for a fixed date fails property (3). As we move closer to that date fiscal policy will be responding to short term shocks, which makes for bad policy.

Although a conditional medium term golden rule goes a long way to satisfying property (3), it fails to take account of spending that is medium but not long term. The clearest example of that today is spending that helps the transition to green energy. For this reason, if I were Chancellor I would task the OBR with calculating how much of the current deficit is due to policy aimed at encouraging this green transition, and adjust the target to exclude this spending. Any government that lets a fiscal rule delay the green transition has got its priorities criminally wrong.

I have seen it recently argued that the last year of the last government showed that deficit based fiscal rules failed, because it didn’t prevent that government from making incredible assumptions about future spending so it could cut taxes. That is a misunderstanding. What the fiscal rules did, combined with an independent OBR forecast, was force the last government to make assumptions that amounted to further austerity in order to make tax cuts. That these plans amounted to further austerity was widely commented on by experts in the independent media. Without a fiscal rule and the OBR to monitor compliance, I’m sure the last government would have claimed that it would cut taxes and increase public spending! [3]

The other fiscal rule that Reeves appears to have adopted, which does come from her predecessor, is for a falling debt to GDP ratio five years ahead. This, when you already have the golden rule, is a terrible fiscal rule. I have not come across a single serious economist who defends it, and plenty of eminent economists who understand the damage it is doing (e.g FT here, or ungated here). The rest of this post is about all the reasons why this rule is not fit for any purpose except keeping economic growth down.

The first point to make is that, if the medium term conditional golden rule is in place, there is no need for an additional rule to achieve property (1). The golden rule does that just fine. In that sense the falling debt to GDP rule is completely superfluous [4]. Unfortunately that rule fails properties (2) and (3), because it discourages much needed investment. This is the reason I sometimes call it the suppressing public investment rule.

Suppressing public investment is exactly what the previous government was doing for fourteen years, and the terrible state of our public sector is partly a result of that. This was perhaps why that government was so attached to this rule. In contrast, Reeves has spoken many times about the need for additional public investment, so it makes no economic sense for her to adopt a rule designed to suppress that investment.

We currently need a surge in public investment to catch up all the ground we have lost. But the case for much higher public investment is even stronger than that, as recent research from the OBR clearly shows. Their paper first shows how public and private investment are really low in the UK compared to other G7 countries.

Public investment began rising towards the G7 average in the first decade of this century, but austerity cuts set that back. Private investment is no better, but that is partly because public and private investment are often complements.

The OBR, using very reasonable assumptions, calculates that if public investment was increased by 1% of GDP permanently, potential output would be 0.4% higher after 5 years. The impact on potential output goes on rising steadily, to reach 2.4% after 50 years. The paper also looks at what these assumptions imply for average rates of return and benefit to cost ratios. Of course the whole point of a good investment strategy is to choose individual projects that have a high return, and make sure these projects are not thwarted by some archaic fiscal rule. What the OBR’s analysis shows clearly is that increasing public investment is an excellent way to help improve the UK’s recently dire growth performance.

The falling debt to GDP rule is classic mediamacro. It comes from the idea that government debt is a 'bad thing' by making false and selective comparisons to household debt, that current levels are 'obviously' too high, and so debt needs to be brought down. It’s a rule that economists advise against but political advisers say is essential to maintain ‘political credibility’, which is code for what non-economists in the media think should happen. Everyone from political journalists to the great and the good like to opine about fiscal rules while having little knowledge. It is they, not economists, the markets or even GOD, that think maintaining such a bad fiscal rule is essential for credibility, and they are wrong about this just as they were wrong about 2010 austerity.

Reeves should take the opportunity of her first budget to consign this rule to the dustbin. The new OBR analysis of public investment provides the perfect excuse to do so, if she needed an excuse. [5] A comment from the National Institute argues that the OBR's analysis may underestimate the impact of public investment on economic growth.   

What should take its place as Reeves’ second fiscal rule? Nothing. You don’t need a second fiscal rule. It serves no purpose, beyond the bad one of suppressing useful public investment. As I argued here, replacing it with a target for falling net public sector worth to GDP is just double counting. It makes sense to look at public sector net worth when looking at sustainability over the longer term (beyond five years), but having it as part of a fiscal rule is not sensible.

Yes, the Conservative opposition will claim that abandoning the falling debt to GDP rule allows the Chancellor to have slightly higher spending (about half a percentage point of GDP, according to the last OBR forecast) and higher public investment. Most voters will be happy about that. No one in the bond market will be worried - why should they be, when the OBR calculates that public investment almost pays for itself in generating higher taxes. [6] Much more importantly, abandoning this rule will allow the Chancellor to expand public investment to boost economic growth and green the economy. Getting rid of the falling debt to GDP rule is really a no-brainer for any Chancellor whose main concern is the health of the economy rather than what the media commentariat might say. 

[1] Part of the cynicism surrounding fiscal rules is a consequence of the last government, which changed fiscal rules even more frequently than the Prime Minister. Sometimes this wasn’t because the rules they replaced would have been broken, but just as a political ploy to wrongfoot the opposition. Essentially the last government used the misconceived media credibility they got from austerity to devalue the concept of a fiscal rule.

[2] Formally, the lower bound for nominal interest rates makes it essential that we have fiscal stimulus to prevent, moderate or recover from a recession. The exact form this conditionality takes is a second order, though important, problem.

[3] There is an issue about the OBR being forced to make forecast assumptions it strongly suspects are false, which I discussed here. This is an issue about the OBR's mandate, not about fiscal rules.

[4] In fact the falling debt to GDP rule has nothing to do with the basic principle of ensuring debt sustainability. Instead it is based on the presumption that the current debt to GDP ratio is too high, and as I discussed in my previous post there is no evidence for this.

[5] If Reeves is planning to keep this silly rule, and has already adjusted her plans so that the rule is met, it is not too late. She could be politically clever and announce both the end of this rule, but also that her fiscal plans would have met the rule anyway, showing that the rule is being ditched on good economic grounds rather than so she can spend more or tax less.

[6] That doesn't mean that long term interest rates will not rise. They may if additional public investment adds to already strong aggregate demand (in the face of weak aggregate supply), and markets anticipate that this will put upward pressure on interest rates. The obvious way to avoid that is to increase taxes.