Labour’s top challenge is how to grow economy
With government debt at 100pc of GDP, fiscal rules would have be relaxed to permit higher borrowing ‘If markets thought Labour was changing the rules to increase government debt, bond yields would soar’
The recent council and mayoral elections brought few surprises. For some time, the financial markets have been assuming that there will soon be a Labour government, probably with a large majority. It is not surprising, therefore, that they barely turned a hair. Yet, as the weeks roll by, more and more people in the markets and among the financial commentariat are bending their thoughts to the question of what a Labour government may do and how this may affect the economy and the markets.
One way Labour could escape from the present fiscal straitjacket would be to alter the rules that supposedly constrain how much the Government can borrow. These rules – the ninth version since fiscal rules began to be set in 1997 – are difficult to understand and relatively easy to manipulate. There is a sound case for reforming them.
But reform is not the same thing as relaxation. With government debt running at about 100pc of GDP and pressure for higher spending on just about all departments, from defence to the NHS, if the markets sniffed that the fiscal rules were being significantly relaxed in order to permit higher borrowing, the result would be decidedly higher bond yields.
That is the last thing that the new government would want, with debt interest at 3.7pc of GDP and 8.4pc of overall government spending. So Labour will make great efforts to avoid this. The lasting beneficial impact of the apparently disastrous Truss/ Kwarteng mini-budget may have been to bring home to Labour the cost of financial incontinence.
One partial way around the fiscal constraints would be for the Treasury to instruct the Bank of England to cease paying interest on the banks’ deposits with it. At current interest rates this would save the Exchequer about £40bn a year, allowing government spending to be increased by just over 3pc. There would be some complications for monetary policy but I believe they could be readily overcome. This measure would effectively be a tax on the banks but it wouldn’t show up in the overall tax burden.
If the Government were to implement this measure, depending on the relative effects of increased government spending and lower bank profits, aggregate demand in the economy may be stronger and this would lead to higher interest rates than would otherwise be the case.
Of course, Labour could attempt to square the fiscal circle by raising all sorts of taxes or introducing new ones, such as some form of wealth tax, in order to fund higher spending. The shadow chancellor has been keen to downplay or even deny such possibilities. But I am not naive enough to be convinced that this rules out major tax rises. Nevertheless, I suspect that Labour would not go down this route to any significant degree. As a share of GDP, tax receipts are nearly at a post-war high. You don’t need to be a fully paid up member of the free market Right to believe that higher taxes are not a good way of boosting economic growth. Another reason a new Labour government should be cautious and conservative with the public finances is that its focus should surely be beyond just the next five years. It should be thinking about a programme lasting two, or perhaps three, parliaments. The only Labour leader to have achieved this was Tony Blair. His three election victories sustained a Labour government from 1997 to 2010.
Some commentators have suggested that reform should focus on the Bank of England, perhaps increasing the inflation target from 2pc to 3pc. Whatever the merits of that in normal times, to do it now, just after we have emerged from a burst of high inflation and at the beginning of a Labour government, would be extremely dangerous. Again, it would send bond yields soaring. In my view, although the Bank’s recent record has not been stellar, reform should focus on broadening the experience and the intellectual diversity of MPC members.
If Labour cannot be very fiscally expansionary and decides that it would not be in its long-term interests to preside over a large increase in the tax burden, while leaving the Bank of England largely alone, what could it do? It would face major problems placating its members and new MPS, eager to build the new Jerusalem.
I suspect that this factor alone makes it likely that Labour would intensify all sorts of regulations on firms and markets, increase workers’ rights and double-down on equalities legislation. All of this would cost the Treasury no money – at least directly. But it would hardly be likely to increase business efficiency or bolster economic growth.
Growth holds the key – and Labour knows it. In this regard it has been encouraging to see the party’s apparent preparedness to radically reform the planning system with a view to permitting and encouraging a faster rate of house building. That’s an issue where making a real difference will require policies sustained over at least two or three parliaments.
So what are the markets likely to make of all this? We are told that there is a significant exodus of wealthy individuals, especially non-doms due to be hit by the impending change in non-dom arrangements introduced by the Tories. This is bound to be accompanied by a some capital flight.
But I doubt institutional and corporate capital will leave the country in large amounts, not because there is any great enthusiasm for a Labour government in the corporate world or the financial markets. Rather, it will be down to the widespread belief that there is unlikely to be a major shift in macro policy or a reduction in the overall competence of government. Make of that what you will.
Roger Bootle is senior independent adviser to Capital Economics. roger.bootle@capitaleconomics.com