Understanding long term interest rates movements over the austerity period and today

 

The first section explains some basic ideas, and those familiar with arbitrage and the natural real rate of interest can skip to the austerity section.

Basics

Longer term interest rates, rates on borrowing for a number of years, are what helps determine the cost of government debt, the cost of long term borrowing by firms and the cost of mortgages. A lot of popular discussion links these longer term rates to the short term interest rate set by central banks. The reason is arbitrage. Someone who buys a longer term asset with a fixed return over five years, say, could instead hold that money in a variable rate account, and arbitrage means that rates will move until lenders are indifferent between the two, so longer term rates and short rates are linked.

By that logic, interest rates on a 5 year bond, say, are just equal to expectations about how the central bank will set short term interest rates over the next five years. It’s not that simple because of liquidity and uncertainty. Having money in a variable rate account normally gives you instant access, while investing in a longer term asset will either tie your money up for a long time or to a potential loss by selling it before term, so lenders want some compensation for this. In addition, what is going to happen to short rates is very uncertain, so most lenders want compensation for taking the risk of betting on a particular forecast.

Guessing how independent central banks will set interest rates in the future is not easy, but the logic behind their actions are pretty clear. Most aim to hit an inflation target, so they will set interest rates at whatever level is required to either keep inflation at target, or get inflation back to target. In crude terms, interest rates act to control aggregate demand, and keeping inflation steady involves getting demand matched up with available supply.

A critical question is therefore what level of interest rates will stabilise inflation in a few years time. That depends on what will happen to aggregate demand, but it also depends on how demand is influenced by interest rates. Demand is mainly determined by real rather than nominal interest rates, where the real rate is the nominal rate less expected inflation, so we want to know what real interest rate will match aggregate demand to supply. That level is often called the natural real interest rate. Judging by historical data the natural real interest rate seems to vary a lot over time. [1]

Most measures of real interest rates fell steadily from 1980 until at least 2000. Above is an example based on US rates (source). While you could argue that rates were unusually high in the 1980s because central banks were squeezing demand to bring inflation down, that doesn’t explain the continuing fall in the 1990s.

We need two more conceptual ideas before going further. The first is the importance of the supply and demand for savings. If, say, a technological revolution produces a large increase in borrowing by firms, but there is no increase in the supply of savings to meet it, real interest rates will rise to encourage more saving and discourage some borrowing. While I tend to discount the idea that the supply of particular assets, like an individual government’s debt, is the critical factor determining the interest rate on that debt [2], at the aggregate level the supply and demand for assets does matter.

The second idea is the distinction between safe assets, where the person borrowing is almost certain to pay back the loan, and other investments where the loan may be only partially paid back. Equities are the main example of the latter, because not only do aggregate share prices move around but any individual company may, in the extreme, go bust. The difference between the two types, returns on safe assets and the return on equity or capital more generally, is called the ‘equity risk premium’, but that gap may not just be about risk. In particular the overall supply and demand for either type of asset can influence this risk premium.

The Financial Crisis and Austerity Period

For more detail on this and the next section I strongly recommend this fascinating discussion between Paul Krugman and Ricardo Caballero. Caballero argues that after 2000 there was a continued fall in the real interest rate on safe assets, much greater than anything happening to the return on capital, and he described this (at the time) as a shortage of safe assets. (This study suggests that the return on capital in the US actually started rising in the 90s.) In other words rather than there being too much government debt around (as many politicians and journalists claimed) there was actually too little.

Was this shortage one reason that the private sector tried to make its own safe assets with mortgage backed securities, the failure of which was the spark that led to the Global Financial Crisis (GFC)? Caballero suggests it was a factor. It would be horribly ironic if the GFC, the impact of which was often misattributed to excessive government borrowing, might itself have been partly caused by governments borrowing too little! But what Caballero’s argument certainly tells us is that attempts in most countries to cut government deficits from 2010 because government debt was dangerously high were especially wrong.

The original sin of austerity was of course to cut government spending in a recession, going against basic macroeconomic teaching understood since Keynes. We now know that policy, as well as delaying and probably diminishing the recovery from the financial crisis, also probably failed to even reduce the government debt to GDP ratio. The argument that economists like myself made was that fiscal consolidation, if required, should wait until the recovery from the recession was all but complete. However, if there was in fact a shortage of safe assets in the form of government debt before the financial crisis, it may well be that the large amount of debt issued as a result of that crisis was a necessary correction for that shortage. Even the excuse for austerity was wrong.

Because safe assets were in short supply, austerity meant that interest rates remained extremely low for a decade after 2010. Government debt was increasing, but this may have simply replaced the hole created by the demise of mortgage backed securities. (For a period a lot of European government debt also stopped being safe.) [3] What is unforgivable over that period is that governments kept public investment low, despite the fact that it was so cheap to borrow. [4] We are suffering the results of that colossal policy mistake in most countries today. The one country that didn’t make that mistake was China, which is the reason they have a state of the art railway network today.

Rising interest rates today

Those days of very low short and longer term interest rates seem to be over. The first point to note is that this is essentially an international phenomenon. Political journalists like to focus on domestic issues when talking about this, but you will not find an explanation for rising longer term interest rates across the globe in anything the UK government has or will do. [5].

One story that follows from the post-GFC discussion above is that we no longer have a shortage of safe assets, and indeed there may now be a glut. The Eurozone crisis ended as a result of the switch in policy by Dragi and the European Central Bank, so that supply is back. In addition the pandemic led to a step increase in the amount of government debt worldwide. Finally, in the US in particular, budget deficits have been large and (unlike in the UK) there are no plans to bring them down.

Another part of the explanation for higher longer term rates that is often discussed is inflationary pressure caused by the US attack on Iran. However what is noticeable about longer term interest rates is that they are higher at all durations. Why should higher oil prices today be adding to inflationary pressure in 20 years time? One answer to that is a point I have noted before, which is the rise of right wing populist and even fascist governments. [6]

Take the worst case scenario, which is that traditionally right wing parties are either being overshadowed by right wing populist parties or are morphing into such parties. (Of course we might get both, as we have in the UK.) That means that periods of right wing populist government become almost inevitable. It is unlikely but not impossible that such governments would actually default on their debt. What is more likely is that they would end, by one means or another, independent central banks and allow inflation to stay permanently and significantly above today’s target levels. For any given level of the real natural rate, that means higher nominal interest rates in the future.

A third factor that may generate more persistent inflationary pressure is the AI boom. Most people believe that the current AI revolution will greatly improve future productivity growth. [7] Prospective higher productivity in the medium term can lead to increases in aggregate demand in the shorter term through two routes. First firms will increase investment in AI. We are already seeing that in the US with the development of AI itself, but that will spread to investment in these models across many other sectors. Second, higher future productivity means higher expected future incomes, and people’s consumption today depends in part on expected future income. (In effect they will spend more today because of a strong stock market.) Just as with a future natural resource boom, demand will increase before supply does, putting additional pressure on inflation and therefore raising the natural rate of interest.

Finally the AI boom itself tends to increase the return on capital, which other things being equal will raise longer term interest rates across the board. Higher future productivity raises the long term natural rate of interest according to standard economic models. This is why we are seeing stock markets remaining strong despite rising interest rates. In addition the investment required to implement AI improvements requires additional corporate borrowing, pushing up longer term interest rates. [8] At the moment that borrowing is concentrated in the tech companies developing AI, but later it may spread more widely as firms adapt to integrate AI into their production methods.

All these stories, with the possible exception of higher oil prices, imply that higher longer term interest rates are here to stay, unless a financial crisis forces central banks to lower short term rates (see [6]). To the extent that this is the result of anticipated productivity gains, it can be viewed as a positive rather than negative development.

If that is the case, what should policymakers do about it? In terms of the distribution from borrowers to lenders not much directly. We may end up judging the era of cheap borrowing after the GFC, rather than conditions today, as an historical oddity. As far as fiscal policy is concerned, responsible governments will at the very least need to stop debt to GDP rising as a result of higher interest rates on government debt. As higher interest rates particularly benefit wealth holders, it makes sense to raise taxes on those who save rather than those who borrow. Cutting public spending makes much less sense as long as private consumption continues to increase..

[1] As aggregate demand varies around supply, then the natural real rate will be approximately the average of real interest rates over a number of years

[2] For the same reason that a sudden shortage of, say, VW cars is unlikely to lead to a large increase in their price.

[3] Another story to explain the low natural real rate of interest popular at the time was secular stagnation (low corporate borrowing because of limited investment opportunities) or a glut of savings associated with China in particular.

[4] Even Ken Rogoff, whose work helped justify austerity, said he didn’t agree with cuts to public investment, which in the UK were critical in stalling the economic recovery.

[5] For some time the rate on UK 10 year government debt has been at the top of the range among major economies. It’s hard to put much stress on domestic political/fiscal factors to explain this when the interest rate on 10 year government bonds in France is 1% below the UK. One possible explanation is the Bank of England unwinding Quantitative Easing. If you really want to relate relatively high rates to UK fiscal decisions, I think the best line to follow is the reduced scope of action created by both a (quite understandable) political unwillingness to cut spending and a commitment not to increase the major tax rates, which reduces the chance of fiscal policy helping to reduce demand thereby putting all the burden on interest rates.

[6] An additional longer term pressure on inflation is climate change. With significant global warming now inevitable, disruption to supplies of food in particular will become more frequent.

[7] Note that this doesn’t necessarily mean that the high equity price of the leading AI companies is justified. You can believe that AI will greatly improve future labour productivity but also believe that the companies producing the AI will find it difficult to capture much of that through monopoly profits. The likelihood of a future productivity boom and who gets the benefits of that boom are separable questions. One quite possible source of a financial crisis is a sudden realisation that AI will not lead to big increases in the profits of those doing the development of these models, making the debt of some of these companies vulnerable.

[8] As noted above, higher future income may encourage a reduction in current saving, whereas what may be required is a rise in current savings relative to income to finance additional investment.

Is the fall of Starmer a warning for the Democratic Party?

 

The political situation of the US and UK in 2026 is very different. In the UK Labour is in power and will stay there for at least another two or three years, but they are threatened by a right wing populist hydra in the form of the Conservatives under its current leader, Reform lead by Farage, the right wing press, Musk via X and hostility from the US government. In the US we have an unpopular fascist administration which is doing all the gerrymandering it can to stop the Democrats winning back the House and possibly the Senate and thereby getting a foothold of resistance to Trump.

Yet in the last few months in the UK we have seen a remarkable internal coup, where the Prime Minister has resigned and been replaced not by another senior minister but by a city mayor who had to win a by-election before he could stage a bloodless [1] takeover. Not only did the UK Prime Minister Keir Starmer lose his job, but also the Chancellor Rachel Reeves. It was both a rather unusual and also very significant event.

Now there are many reasons why MPs decided that Starmer had to be replaced, despite leading Labour to an unprecedented election victory just two years earlier. I will not go through a list of his policy mistakes because others have done this many times over. However I would argue that nothing on that list quite justifies the end result. In my view most MPs were happy to see a bloodless takeover by Andy Burnham for reasons of simple self-preservation. Although governments in mid-term often suffer in opinion polls and local elections, the scale of the deterioration in  Labour’s support under Starmer was too alarming.

Once again there are various reasons why Labour’s polling collapsed. For a start it didn’t start that strong. Labour won so many seats in parliament with an unusually low vote share because the Conservative party lost so much support to Farage and Reform on the right, and in the centre to the more socially liberal Liberal Democrats. But I think a goodcase can be made that the main reason Labour support collapsed so much after the election was that voters on the liberal left - normally Labour’s core support - abandoned the party to either not vote or vote for the Greens, Liberal Democrats or Scottish or Welsh nationalists.

The reason why many of Labour’s core electorate deserted the party, as I outlined many times before it happened, was that Starmer chose to adopt on social issues like immigration and asylum a pretty illiberal policy stance and rhetoric. Starmer’s own speech in May last year, which I blogged about here, was indicative of how far the government seemed prepared to go in a doomed attempt to win votes from right wing populists. It was this social rather than economic positioning that led to Starmer’s downfall. [2]

For that reason, I think it is fair to say that voters on the left in the UK were critical in bringing down Prime Minister Starmer. Labour’s popularity since Burnham’s takeover has improved significantly, in large part because a lot of those votes have come back to Labour. How permanent that return will be will depend on what Burnham does over the next year rather than what he says.

In the US there are no significant third parties like the Greens or Liberal Democrats, and any left liberal voter worth their salt right now would vote Democrat to help defeat Trump and a Republican party that seems happy to let the US be a fascist state. Instead the relevant action there is in primaries, where Democrat voters get to choose their candidate. One notable feature of some of these primaries is that candidates very much to the left of the party have been winning. Some are members of Democratic Socialists of America or DSA, whose membership has increased dramatically in the last decade.

At the moment numbers remain modest, but according to some CBS analysis candidates endorsed by either the DSA or another leftish group, Justice Democrats, have won two thirds of the House primaries in which they have competed. In addition others not formally connected to these groups, like Abdul El-Sayed in the senate race for Michigan, have won campaigning on similar left wing issues.

In many ways none of this should be surprising, and nor is it very new. Joe Biden's main challenger for the presidential nomination was Bernie Sanders. As President Biden often sought to include rather than exclude the party’s left in formulating various policies. Although US growth has been relatively strong, much of that has gone to the wealthy as the profit share has increased and the wage share fallen. (Something, incidentally, that has not happened in the UK.) Often the politics that suffers when right wing populism gains strength is the centre, as can be seen most dramatically in France. However the centre often survives because enough voters on the left believe, rightly or wrongly, that politicians from the centre are more likely to be able to stop a right wing populist victory than politicians from the left.

What Starmer’s fate shows is that there are limits to that argument. An uncharismatic leader from the centre, who attempts to defeat the right by adopting or validating the right’s own rhetoric, can alienate voters on the left sufficiently that others in the party believe that leader can no longer win, and needs to be replaced by someone who is or appears to be more left wing. The relevant comparison to Starmer's fall in the UK in the US is not the 2026 midterms, but the contest for who will run for President in 2028.

In the UK the key issue that alienated core Labour supporters from their leadership was immigration and asylum, and the rhetoric and policies the Labour government adopted on this issue. Is there an issue in the US where enough Democrat voters could become alienated from the party leadership’s position? There is plenty of choice, but one issue where Democrat voters seem seriously adrift from their leadership right now involves Israel.

In a poll in July, just over 50% of Democrat voters said they believed that Israel’s actions in Gaza amounted to genocide. A more recent poll that looked at Democrats likely to vote in the first six ballots to decide the next Democratic Presidential nominee found overwhelming majorities believing that Israel was guilty of genocide, and that therefore the US should cut off arms sales. Yet rather than bending towards this shift in opinion among its supporters, parts of the Democratic party leadership seems to be reaffirming its support for Israel’s actions. There appear to be influential Democrats who would rather see Democratic candidates on the left, or those who acknowledge Israel’s genocide, defeated even if it means a Republican victory. (There are UK parallels with Corbyn’s 2019 defeat to right wing populist Johnson here.) There are various reasons why a gap has opened up between Democratic voters and politicians on this issue, one of which is simply inertia.

Elections are not generally decided on foreign policy issues, but equally foreign policy does not generally include arming a country that is believed to be carrying out a genocide. This would not be the first time that foreign wars have split the Democratic party. Those in both the US and UK who believe that their supporters on the left are both an annoyance and a liability in winning elections should take note of Keir Starmer’s demise.

[1] By bloodless I mean without a contest election.

[2] The position of Starmer’s senior political advisor, before he resigned months ahead of Starmer, is often called Blue Labour, and is generally understood to combine traditional left wing Labour positions on economic issues (eg pro-worker and union, open to public ownership of key utilities) with a much more conservative position on social issues like immigration.

Media regulation is partly about protecting individuals and groups from powerful organisations and the wealthy, but it is also about protecting democracy.

 

Are pile-ons by the media on individuals acceptable? It depends on the individual. If it’s a politician then probably yes, in that the politician has or is asking to have massive power and so a lot of scrutiny should come with that. Some argue the same for a celebrity, but in that case it is worth asking why someone who happens to be well known for pursuing their particular talents has to give up their privacy as a result.

Celebrities by definition are individuals the public are interested in, but there is an important distinction between what people are interested in and what is called the public interest. People love gossip, but that does not mean that the individual the gossip is about loses their human rights. Human rights exist in part to protect individuals from the wishes of the masses.

Consider now someone who is not a politician or celebrity, but who has a minor public presence. Imagine an academic, for example, that writes a blog and the occasional article for public consumption, and who has sometimes advised political parties. In other words someone like myself. Suppose they write something in their blog that is controversial in some quarters, or embarrassing to some politician, or suppose what they write is misquoted by a Prime Minister and they complain. As a result of these activities, certain newspapers that are allied to those politicians decide to see if they can discredit the academic in some way. There follows a series of articles about the academic in which events or facts in their past are used selectively with the aim of discrediting them in the reader’s eye. Is that OK, and if it is not, why?

You could say that by doing anything public, particularly doing something of political interest, means that the academic is fair game for the media. But that very phrase ‘fair game’ is revealing. There is a power asymmetry here. Media outlets are very powerful organisations, because their audience is far greater than any academic’s blog and what they write has far greater influence. The academic doesn’t get a right of reply to what the newspapers say. There are legal options in certain cases, but these are limited and very expensive. So it is quite possible for the press to unjustifiably ruin this academic’s reputation, and there is currently no recourse readily available to the individual that has been wrongly represented by the press that will have the same impact as the original articles attacking them.

I think most people would agree that such an outcome is very unfair, and if it happened an injustice had been done. The academic has been targeted and misrepresented just because they had opinions or expertise that was politically awkward for certain media outlets. This outcome is perfectly possible today because large sections of our media have power without any accountability. They are not regulated in any meaningful way.

Now suppose that in the course of the newspaper’s digging they uncover that the academic had done something that an academic should not do. As a result, the academic loses their job. The newspaper can legitimately claim that they have exposed some wrongdoing, even if their motives for doing so are dubious. The academic and others can blame the newspaper in this case, but I doubt that would generate much public sympathy.

But what if the newspaper decides to continue their attacks on the individual after they lose their job, perhaps because it generates clicks, because it’s August or because the newspaper wants to deter other academics from attacking their politics or politicians. None of these are good reasons for hounding someone who has just lost their job. This is unfair and cruel. We are back to power without accountability. [1]

Why should newspapers, almost uniquely in the UK, be organisations that are unaccountable for what they do? A glib answer is to uphold press freedom. But those who use that term should always be asked ‘freedom to do what’. Freedom to hound a vulnerable individual because that is what readers are interested in? A better answer is that any accountability would put constraints on newspapers’ actions that would be against the public interest. In particular, any framework of accountability would need to be set up by the government, and that would threaten the freedom of the press to hold the government to account.

As an all encompassing defence this is nonsense. Suppose, for example, there was a press regulator independent of the government who could, when a newspaper publishes more than one article attacking the reputation of an individual who is not a politician, demand that this individual be given the right of reply (directly or indirectly) in the pages of that newspaper. In what way does that inhibit the newspaper from holding the government to account? In what way does it inhibit the newspaper in any way? apart perhaps from ensuring their journalism is not obviously flawed

What I have said about the imbalance of power between the media and an individual also applies to groups of individuals. It is routine for the right wing press to focus on crimes committed by immigrants or non-white criminals, because this gives the impression that foreigners or non-whites are more likely to commit crimes than they actually are. One anonymous person who follows me on X has taken to regularly sending me posts about individual crimes committed by immigrants. And for many that tactic works, of course, which may be why the press does it.

In these circumstances a regulator could insist that representatives of the groups the newspaper is trying to denigrate have some form of voice within the pages of that newspaper. These representatives could simply present the statistical evidence rather than the selected individual cases, and any caveats associated with that data. Once again, this would not deter the newspaper from holding the government to account. [2]

Protecting individuals and groups of individuals from being unjustly maligned by the UK press and media more generally does nothing to restrict the freedom of press where it matters. But what does restrict the ability of the media to hold politicians and others to account is when the media is controlled by wealthy individuals with clear political interests. In that situation the press can fail to hold the government, certain politicians or those with power to account.

In the US today we have, at best, a right wing populist government that acts very much like a plutocracy, where particular very wealthy individuals can be given or exert great power. Trump’s second term has not just created a plutocracy, but has brought with it a spate of purchases by the very wealthy of US media outlets. As there is nothing to suggest that US media has suddenly become more profitable, this rather suggests that media ownership is often about getting power and influence rather than just making money. [3] A common model for right wing populism involves state control of the media not through direct ownership or censorship, but through media ownership by wealthy individuals linked to or aligned with the government.

Exactly the same pattern could be repeated in the UK, as the role of wealthy individuals in politics here continues to grow rapidly. This is why in the UK and elsewhere good media regulation has become an essential part of having an effective democracy. Without it, we risk having a democracy in name only, where the reality is that money can buy a wealthy individual the equivalent of a great many thousands of votes, as well as the means to intimidate or harm anyone who gets in their way or in their friend’s way, or just to make a political point. [4]

Sir Brian Leveson began his inquiry by asking ‘who guards the guardians’, with the idea that the press were a key part of the UK’s guardians of democracy. In the US under what many would currently call the fascist administration of Donald Trump, you would have to ask how good a job the media there has done at guarding democracy. Parts of the US media have actively facilitated that fascist takeover, along with the election denying, blatant corruption on a massive scale, state violence, unprovoked military aggression and vote suppression that has gone along with it. Perhaps this is what can happen when no one guards the guardians, as currently happens with the UK press.

[1] Of course the case that you know I’m alluding to here was far, far worse than a maligned academic blogger. The motive for much of the huge volume of articles attacking Arday after he resigned was not to expose or deter academic plagiarism, but to use him as a proxy for an attack on EDI. In other words he was attacked because he was black. We know this partly because there have been plenty of plagiarism cases in the past that have not generated anything like this level of coverage, and also because of what many of those articles actually said.

Was this done because newspaper journalists, editors and owners are racist, or just because it furthered a particular political agenda that they supported? I have no idea, although I can think of another example that is consistent with racism. Perhaps the more relevant point to make is that at present there is nothing stopping a wealthy racist from buying a newspaper and then deliberately targeting non-white individuals. Nothing in our current system of press non-regulation would stop that happening.

[2] The attacks on Arday were also inevitably attacks on black academics in general, with the insinuation that they got their posts because of EDI rather than on merit. In my own experience as an academic on appointment boards I have never known EDI to be used to select a candidate who was not the best on purely meritocratic grounds, which is as it is intended to be. In addition the incentive to improve a department’s research profile is infinitely stronger than anything in EDI.

The quality of most of the journalism in this instance, in terms of having any understanding of how academia works, seems to be pretty poor. In the case of Cambridge about 0.4% of professors at Cambridge are black, which is a simple statistic that exposes how ludicrous these attacks on EDI in newspapers are. To say there is “some circumstantial evidence” that EDI was critical in this appointment seems to amount to (1) EDI exists (2) Cambridge University made a lot of Arday’s appointment after the decision was made (surprise, surprise given the above) and (3) universities were very woke in 2023! In other words no evidence at all.

[3] What has happened in the US is just another indication that newspapers are not purely profit maximising organisations, but that they are also a way of giving the owner considerable political power.

[4] This media also has the ability to drown out good ideas by constantly resurrecting zombie ideas.

Signs of recovery in comparative UK economic growth

 

I haven’t talked about recent UK macroeconomic data for some time, mainly because there hasn’t been any new story to tell. To recap, growth in the UK relative to other comparable countries was strong in the three decades before 2010, but then the UK entered a period of relative decline, exacerbated by Brexit. In addition the UK had a terrible pandemic, not just in terms of government policy and therefore deaths but also in terms of lost GDP. The economy bounced back as others did around the world, but the ground we lost in the pandemic relative to other G7 countries was never made up.  Whether that is because of UK policy during the pandemic or the ongoing negative effects of Brexit is hard to tell. Below is a chart that ends at the end of 2023. [1]

The UK was not the worst performer over this period, with both German and Japanese GDP at the end of 2023 hardly above average 2019 levels. But next worst was the UK, with GDP at the end of 2023 just 2.5% above its 2019 average, and above us was France (4%), Italy (5.5%), Canada (10%) with the US leading the pack at over 13%.

The chart below shows what has happened from 2024 until the second quarter of this year, and I have reset the base year to 2024 to make the chart as clear as possible.

Over this period the US continues to grow more rapidly, in large part because of the AI boom in their tech sector. Next are Canada and the UK, where growth between 2026Q2 and the 2024 average was around 2.5%. Nothing spectacular, but much better than in the remaining four G7 countries, where the comparable figure is between one and one and a half percent.

Of course this is just two years, but I think it is consistent enough to warrant the title to this post, and more informative than the quarterly focus of most news reporting. It’s also more informative than the ONS data release, where the international comparison involves a table of quarter on quarter growth rates! Whereas in 2022 and 2023 the UK economy appeared stagnant, since 2024 we have seen modest growth.

This is good news given that growth may still be inhibited to some extent by the impact of the UK leaving the EU. There are other positive signs. In the past I have given, where possible, figures for GDP per capita, because immigration has flattered the GDP numbers. In contrast in the first half of 2026 UK growth in GDP per head is much the same as growth in GDP, as immigration levels have been quite low.

More positive still is the source of UK growth. As I have noted many times, levels of UK investment are consistently below investment in other countries. Yet if we look at the growth between the first quarter of 2026 [2] and average 2019 levels, UK gross fixed capital formation has increased by almost 13%, nearly double the growth rate of UK GDP over that period. In comparative terms we are still behind the US (AI again) and Italy (where investment growth has boomed, exceeded the US), but we are well ahead of the other four G7 countries. The latest UK data shows continuing strong growth in the second quarter of 2016.

There is even positive recent news on productivity. As John Van Reenen and others have recently pointed out, if we move away from the current Labour Force Survey and instead use the data the ONS is likely to soon adopt, between 2024 Q3 and 2026 Q1 UK productivity increased by 2.4 per cent, which is pretty good by recent UK standards.

On one level none of this is too surprising. The UK’s comparative economic performance since 2010 has been terrible, and so the beginnings of some sort of recovery from that is not totally unexpected. If I am right that the UK’s comparative decline since 2010 has been largely due to large government policy errors, then a change of government for the better could well signal the start of any recovery.

Of course, as we found out in 2010, economic recoveries are particularly fragile in the early stages. Any complete recovery would probably require reversing the policy errors previously made, on Brexit in particular. International uncertainties remain, although all G7 countries are affected by those to varying degrees. Yet it is nice to write something positive about the UK economy for a change.

[1] I have updated the OECD data to add a guess for 2026Q2 for Japan, and the latest data for the UK for that quarter which was released by the ONS last week. My guess for Japan turned out to be pretty good. 

[2] OECD data for 2016Q2 is not yet available for most G7 economies.

Unpicking the legacy of neoliberalism

 

Neoliberalism as an overarching ideology for UK government died with the Brexit referendum in 2016, just as it did in the US with Trump’s election that year. Its last hurrah in the UK was austerity, although whether squeezing the state by reducing the quality of public provision rather than the amount the state does counts as neoliberal is a good topic for discussion. But Johnson’s right wing populist government in the UK did not mean that the neoliberalism of the previous thirty odd years was completely swept away. Much remained, which is why Prime Minister Burnham can legitimately claim to want to end forty years of neoliberalism.

Robert Shrimsley asks where is a modern day Thatcher to fight what Burnham hopes to do? Most politicians on the right nowadays seem keener on fighting culture wars and immigrants, in a kind of horrific beauty contest to see who can be nastier to asylum seekers, Muslims or other minorities. Indeed you can argue, as I have done in the past, that right wing populism is the inevitable legacy of neoliberalism in practice.

However there is another reason why there is no current equivalent of Thatcher, and that is because defending neoliberalism today is too hard an ask. So many of the claims made under the banner of neoliberalism thirty years ago are questionable at best and in some cases clearly untrue.

I have argued elsewhere that neoliberalism in practice, or neoliberalism in government, is essentially about acting in the interests of business and those that run them. I prefer this definition to anything involving markets because I think it is more accurate in describing what neoliberal governments do. Of course neoliberal politicians and neoliberal advocates more generally extol the virtues of free markets when arguing against regulations, for example, but not when it comes to breaking up monopolies or large firms. As Ronald Coase pointed out, the firm is in many ways an alternative to the transaction costs that would be incurred by numerous markets.

It is more widely recognised that definitions of neoliberalism based around a smaller, less active state are also inadequate. Neoliberal governments actively used legislation to diminish the power of trade unions, for example, because this was in the interests of business.

The central claim of neoliberalism is that if governments supported the interests of business in general [1] then society as well as business would benefit. Businesses dislike regulations and taxes imposed on them, so the claim is that if these regulations and taxes were reduced then businesses will grow faster leading to a general increase in prosperity. It is that corporations or privately owned businesses are better at providing goods and services than the government, so where possible the government should privatise or out source such activities to the private sector. Those who run firms need strong incentives, so taxes on high incomes should be reduced.

With the advent of Thatcher and Reagan these neoliberal claims were difficult to evaluate empirically, and support tended to focus on the inadequacies of the governments they were replacing. That is no longer the case. We can directly compare the experience before and after the 1980s, and see whether the neoliberal arguments hold up.

For example we can compare rates of economic growth, or growth in living standards, before and after the early 1980s, as Michael Jacobs does here. For the UK the simple comparison suggests neoliberalism reduced growth rates, although as Michael says we cannot know what would have happened if neoliberalism had never happened. I have noted in the past that this simple comparison is likely to be unfair to neoliberalism because the pre-neoliberal years benefited from a recovery from the devastation of WWII.

What about comparisons between more or less neoliberal economies over a common time period? If you asked what the greatest economic success story of recent times has been, I think it would have to be China. A lot of that is due to China’s integration into globalisation, and its adoption of a market economy, but the Chinese economy can hardly be described as neoliberal. The Chinese state maintains far more economic control than it ever did in the pre-1980s UK, for example, but this has not appeared to inhibit its continuing growth and development. Today China is also at the forefront of innovation. [2]

A clear empirical refutation of neoliberal claims that regulations inhibit growth and should therefore be reduced is the Global Financial Crisis of 2008/9. Deregulation of the financial sectors in the US and most of Europe brought economic disaster. It is a testament to the continuing power and influence of neoliberal ideology that even today politicians on the right and centre call for a reduction in red tape as a means to promote growth, with hardly anyone noting that is what was said about the financial sector before the GFC. Nevertheless it is hard to deny that stronger financial market regulation could have either avoided the crisis or greatly reduced its impact, and that the neoliberal ideology of deregulation was at least in part responsible for letting that crisis happen.

Of course one failure of deregulation, however large, does not imply that all regulations are always beneficial. But neoliberal governments did not argue that regulations should be judged on their merits, but rather that regulations were almost always bad for growth and bad for society. The Global Financial Crisis shows that argument to be wrong. Other examples of where deregulation has had harmful effects are not hard to find.

While regulations are often essential in particular industries and markets (as economists without a political axe to grind have always understood, of course [3]), we are becoming increasingly aware that if left to itself the private sector can sacrifice the future for the present. While thoughtful neoliberals have never denied the existence of market externalities, in practice neoliberal politicians tend to downplay their existence. Climate Change has been described as the greatest market failure ever seen. Government action, particularly through promoting in various ways innovations in green energy (see [2]), has been essential to reducing carbon emissions, although we still do not know if it has been too little too late. [4] Those promoting neoliberalism have often impeded rather than helped this endeavour to save human civilisation as we know it.

The idea that private sector ownership will always produce better outcomes than social (government) control has been dealt a severe blow in the UK by developments in the water industry. It is not my area of expertise, and it may be that the true story is not as simple as it appears, but in this particular case the combination of private ownership of a natural monopoly plus external regulation has produced a crisis today on various levels. It is another example of why any serious attempt to resell neoliberalism faces a tough task.

Finally, a key part of the neoliberal revolution in both the UK and US was a substantial reduction in taxes on top incomes and also on profits. The idea was that the more business leaders and firms are given financial incentives, the more wealth they will create for society as a whole (‘trickle down economics’). Few would dispute that incentives are important, but whether they remain important to those already on very high incomes is questionable.

Instead these tax reductions seem to have had a significant incentive effect on firms and CEO behaviour in a more negative direction. When taxes had been very high, there was not much point in CEOs devoting much effort into raising their salary. When taxes fell, that was no longer the case, and since the 1980s we have seen a significant rise in CEO pre-tax salaries relative to the average wage (from around x20 in the 1970s to x130 today.) This is a result of the combination of incentives and the bargaining power of CEOs, rather than any increase in CEO productivity. In the US a reduction in top taxes may also have led to a marked rise in the share of dividends in national income.

The net effect has been to reverse the post-war trend of a declining income share for the top 1% or 0.1%. The growth figures cited above suggest that this increasing share has come at the expense of the rest of the population. The most marked impact of this increased inequality has been the involvement of some wealthy individuals in right wing politics, most notably in the US. This is one of the direct links between neoliberalism and the rise of a right wing populist plutocracy. One of the strongest arguments against neoliberalism is that it opened the door to Trump and populist plutocracy. 

None of this implies that neoliberalism has no redeeming features, or that regulation and public ownership are always optimal. What it means is that the focus is on the form of interventions that the government can make, rather than whether any intervention is necessary. It is about the type of industrial policy, rather than whether there should be an industrial policy at all. It is about the best way the public can regain control over natural monopolies, which may or may not include ownership. These will be the important debates of Burnham’s premiership.

Of course losing the intellectual argument doesn’t mean that neoliberal ideas will disappear from public debate. The right’s dominance of the media, and the fact that a minority have done extremely well out of neoliberalism, will ensure that these tropes never go away. But it does mean that the interesting debates will be elsewhere, involving how best to unpick neoliberalism’s legacy.

[1] Not the interests of some firms against the interests of other firms, which is what often happens in a right wing populist plutocracy.

[2] To take one example, China is now at the frontier in terms of solar energy production. A recent paper examines how this was achieved as a result of competing innovation subsidies between Chinese cities.

[3] I talk about why economics is essential to any intellectual critique of neoliberalism here

[4] As Mariana Mazzucato has pointed out for the US, rather than the state ‘getting in the way’ of innovation it has often been the driver of innovation.

Long term fiscal projections are a good antidote to politicians talking about tax cuts

 

Every July the OBR publishes fiscal projections looking fifty years ahead. Each year the headline is the same. The public finances are on an unsustainable path, and if nothing is done government debt will be at some record level in half a century’s time. It’s a signal for general hand wringing.

The first point to make is that this has nothing to do with current government policy. This Telegraph headline is predictably silly, unless they believe Burnham will be Prime Minister for a very long time. The UK’s fiscal rules ensure that current policy is sustainable. Instead the report is about longer term trends in government spending and tax receipts. As the report says repeatedly, it is not a forecast because the government will act to ensure that debt remains sustainable.

It is also wrong to say that it’s just not possible to forecast fifty years ahead so the numbers are meaningless. This is not a normal macroeconomic forecast. For reasons that I will discuss below, the assumptions made about long term GDP growth are not central to the analysis, even though the report spends a considerable amount of time on them.

Instead the interest lies in what the critical long term fiscal pressures are, and what they might imply for future governments. Most of these pressures are on the spending side, as a simplified version of the reports Table 3.1 below shows

OBR’s Central Fiscal 50 year Projection: source

% of GDP	FY 2030/1	FY 2075/6
Health	8.4	13.5
Adult Social Care	1.2	1.8
Education	4.3	3.4
State Pension	5.0	8.6
Other welfare benefits	6.2	6.4
Public sector pensions	1.2	0.9
Defence	2.7	3.5
Other	10.9	10.6
Total	39.8	48.6

The share of total government receipts (mainly taxes) in GDP stays constant between the two periods at 42.7% of GDP. (There are offsetting small changes in the GDP shares of particular taxes.) So inevitably the increase in spending means the deficit steadily increases in an unsustainable way. This is only as interesting as the reasons why certain items of public spending are rising as a share of GDP.

The most obvious story is the state pension, where the triple lock ensures that the state pension rises faster than GDP over time. If governments are unable to end the triple lock, they will have to cut other areas of spending substantially or raise taxes substantially. As far as I know no leading politician has addressed this, and few in the media ever question them on this.

More interesting is health and social care. That the share of total GDP going to health and care spending has risen substantially in the past and is likely to continue to do so is something I have emphasised whenever I get the chance, starting from when Osborne’s lied that he was ‘protecting’ health spending by keeping that share constant. (A lie once again accepted by most of our wonderful media.) But the report’s analysis of why this trend continues in the future is interesting.

If you think this is all about an ageing population, you are only a bit right. The population is certainly ageing in the report’s projections, and the UK population starts to fall beyond 2055 because of a low birth rate, but the OBR think that only accounts for around a fifth of the rising GDP share of spending on health. Far more important is low productivity in health services (compared to the economy as a whole) and the fact that as people get richer they want to spend a rising share of their income on health.

The size of neither of these two more important factors is set in stone. Trends in expenditure shares are likely to level off at some point. AI may improve at least some aspects of health service productivity, although face to face care is always going to be central. Where I am more optimistic is that additional spending on prevention may reduce the need for ultimately much more expensive spending on treatment, but the problem there is getting governments to devote resources to prevention.

It is also interesting what items of public spending are not causing problems. Welfare spending other than the state pension, for example, far from being ‘out of control’ remains pretty constant as a share of GDP. Nor do pensions in the public sector create a problem. A falling population generated by lower births leads to a marked fall in spending on education, offset by higher defence spending. (Who knows what defence spending will need to be in twenty, let alone fifty, years time.)

The report is very good in presenting various scenarios alongside the central projection. However I have one important quibble. They present two alternative projections for productivity, one better and one worse than their central projection. However in these exercises they hold public spending constant in real terms, so higher productivity and growth substantially reduces the extent of increasing deficits (because higher growth automatically raises tax receipts).

I think this is misleading, and goes against their default assumption about public spending. It also makes little economic sense. Public services are not inferior goods. So as people get richer, other things being equal, they want more public spending. As they note in Chart 5.5, if they assume more realistically that public spending will rise in line with better GDP growth then the fiscal benefits of higher productivity are much smaller. This quibble is important because there is a danger that politicians will think that better growth will solve longer term fiscal problems, when it will not. It is also why I say above that the assumptions made about long term growth are not critical to the main message of the report.

Although some of the assumptions about the triple lock and health spending may be too pessimistic, I doubt if all these pressures on public spending will disappear. Indeed some pressures may be neglected in the OBR’s analysis. The most obvious to me as I write from a part of the country that has seen no rain and very high temperatures for over a month is the need for climate change adaptation. In addition, as the Prime Minister has made clear, there is the need to provide some kind of state insurance for the costs of social care for the elderly. (This is good on what other countries do.) We have also not acted on the lessons from the pandemic, many of which require spending more money.

This leads to what for me is the main message of the report, which is that taxes are almost certain to continue rising over the longer term. It is a message that pretty well all politicians do not want to hear, and instead pretend the opposite with talk of tax cuts. As usual it is the Conservative party that is the main source of this problem, always talking about cutting taxes but refusing to consider reducing the scope of the state in areas which might dent its popularity (like the triple lock). Yes, you can cut tax by stripping the quality of public services to the bone, but Osborne did that and public services have yet to recover.

But ultimately we get the politicians our media tolerates. Journalists have become very zealous at asking Labour politicians how they will pay for any additional spending, but rather less adept at doing the same for promises of lower taxes. This report provides ideal ammunition for any journalist prepared to do this. But as I have noted many times, journalists have little incentive to bother politicians with facts or expert analysis.