Labour’s calamitous first 100 days in office have now been trumped by an even more calamitous first Budget. Labour promised to make economic growth its “number one priority” and to restore fiscal stability. Instead, the Budget is severely damaging to growth, while the enormous increase in borrowing – £140bn more than the Tories planned – is already spooking the bond markets. You don’t have to take my word for it – the Office of Budget Responsibility (OBR) says so. Like other independent economists I have been critical of the OBR, but they have been brave enough – in suitably cautious and technocratic officialese – to torpedo this Budget’s credibility.
They have downgraded their economic growth projections for the years 2026, 2027 and 2028, while simultaneously increasing their forecasts for inflation and interest rates. The OBR has also refused to back Chancellor Reeves’s claim of a £22bn “black hole”. Reeves is relying on her public sector investment blitz to spark a similar rise in business investment, but instead the OBR have lowered their forecasts of private sector investment due to higher taxes and interest rates. Unfortunately, I see three key risk factors – restrictive monetary policy, damaged business and investor confidence, and excessive reliance on foreign capital – that mean the OBR is not being pessimistic enough. These are discussed below.
The OBR forecasts annual nominal GDP growth of 4% in the next few years (real growth of roughly 1.5% and inflation of 2.5%). History shows that broad money* growth needs to be in the 4-7% range to be consistent with that forecast. Actual broad money growth over the last two years has only been around 1%, reflecting very weak demand for bank credit, especially from small businesses. The OBR pays no attention to this variable, and the BoE very little, yet forecasts of inflation that consider money growth have been much more accurate than OBR and BoE forecasts. However, the OBR is almost certainly correct that the BoE will react to the Budget by slowing the pace of rate cuts. This means that money growth is likely to remain far too low to “finance” even the moderate growth forecast by the OBR, particularly if the Bank continues its programme of selling its bond portfolio**. With the UK inflation rate having fallen to 1.7% Bank Rate at 4.75% is also now far too high in ‘real’ terms for what is now a highly indebted economy. Therefore, current monetary policy poses a major recession risk to the UK economy in 2025/26.
Although they have rightly cut their forecasts of business investment the OBR may be greatly underestimating the damage to business, investor and household confidence that has been done by this Budget and the political and policy shambles that have preceded it and accompanied it. Apart from higher taxes and interest rates business sentiment has also been shaken by costly increases in worker’s rights, a sharp rise in the minimum wage and the increasing costs of the accelerated drive to net zero.
Before the election Health Secretary Wes Streeting signalled that major reforms to the NHS were likely, and Business Secretary Reynolds promised to continue the free trade drive, but both these growth initiatives seem to have run into the sand. Confidence is tricky to measure – though various surveys do show marked drops – and difficult to feed into economic models. Anecdotally, my own scans of the media, discussions with family, friends, and ex-colleagues, and conversations overheard reveal a sense of shock and disappointment that I haven’t witnessed before. The eminent economist Lord Keynes emphasised the importance of the emotions that govern economic behaviour and decision making, what he called “animal spirits”. My assessment is that the productive sector’s “animal spirits” have been thoroughly trashed. There is a sense of betrayal at the broken promises and dishonesty, alarm at the profound lack of understanding of markets and business, and disbelief at the political maladroitness and administrative incompetence.
The sheer scale of the proposed transfer of resources from the private sector to the public sector is staggering. Government spending as a % of GDP is aimed to reach 45% on a sustained basis, much higher than the post-war average of 39%. Public spending is to rise by an average of £70bn per annum, of which two thirds is to go on current spending and only one third on capital spending. The UK public sector has a poor record of managing capital investment programmes, with new quangos such as the National Wealth Fund and Great British Energy likely to be particularly hopeless. Most of the rise in current spending is to go on higher wages and increased public sector employment. The OBR estimates that by the time of the next election public sector employment will be 400 000 higher than previously forecast. The Budget aims to raise £40bn*** in extra taxation per annum, of which the main measure is the £25bn “tax on jobs” (a description used by Reeves) through higher employer National Insurance contributions (NIC’s). The OBR consequently estimates that private sector employment will be 600 000 lower than previously forecast. Since the pandemic public sector productivity has fallen by 7% and is no higher now than it was 30 years ago. In that same time private sector productivity has risen by 50%. Yet public sector workers are receiving inflation-busting pay rises with no reform conditions attached. The increase in the employer NIC’s rate is not being paid by the public sector. In contrast, those working in the private sector face weak or no pay growth, combined with increased job insecurity and much less generous pensions. This iniquitous and economically damaging divergence will be the source of increasing public discord in the years ahead.
The UK has run a large current account deficit – ranging from 2-6% of GDP – in each of the last 25 years and the OBR forecasts continued current account deficits of around 3.5% of GDP in each of the next five years. UK net foreign international liabilities (overseas assets minus international liabilities) currently stand at around $ 1 trillion (30% of GDP) and could then rise to $ 1.5-1.7 trillion by 2030. The OBR assumes that the requisite financing of these deficits will continue without serious consequences. This is extremely complacent. We are consuming more than we are producing and financing this by borrowing from foreigners. In common parlance we are “living beyond our means”. This process can go on for a long time, as it already has, but it cannot go on indefinitely. Policymakers seem completely unaware of the dangers. Ed Miliband’s manic drive to net zero will not only raise the UK’s already uncompetitive electricity costs even higher, it will also result in a significant increase in imports of electricity and oil and gas.
As time goes on, the UK is thus ever more vulnerable to a loss of confidence by foreign investors. You don’t have to have an economics degree to understand that if domestic businesses and investors are losing confidence then it is likely that foreign businesses and investors will too. It is notable that in recent weeks the 10-year UK government bond yield has risen from 3.8% to almost 4.5%. UK bond yields are now higher than in the US, yet Sterling has fallen by 4% against the $ over the same period. This is not yet a crisis, but the direction of travel is ominous. The OBR also complacently assumes a benign outlook for the global economy in its UK forecast, yet there are clear signs of underlying weakness in the previously strong US economy, while the EU continues to stagnate, and China seems to be failing in its efforts to stimulate recovery. Our biggest trading partner has a new President who plans to impose a 10% tariff on all imports. This is not a world where you want to be dependent on the “kindness of strangers”.
The OBR forecasts slightly higher growth in 2025, mainly based on the planned surge in current public sector spending. This is a shaky basis for continued economic recovery and could easily be overwhelmed by the impact of a collapse in confidence and weak money growth. There is thus a high risk of the UK economy stagnating or going into outright recession in the next two years. This would play havoc with the government’s economic plans. Given how poorly they have started their term of office, in benign economic conditions and a commanding parliamentary position, how confident can one be about their ability to respond to a real crisis?
The new Leader of the Opposition made a compelling case in her leadership campaign that the Tory Party needed to take time to cohere round a set of agreed principles before working on detailed policy prescriptions. This is the model followed by Mrs Thatcher in the four-year period she was Leader of the Opposition. However, Mrs Badenoch might be well advised to recall that a previous PM, Harold Macmillan, said that politician’s plans were regularly derailed by “events, dear boy, events”. The next election may be nearly five years away, but well before then the country will need to demonstrate that it has a government-in-waiting that has a credible plan to get us out of the mess.
The good news is that this is possible. Bad policy choices can be reversed. Central to this plan must be radical reform of the public sector, particularly the NHS, and a more realistic net zero policy based around nuclear power. The UK still has many strengths – amongst others a dynamic and competitive services sector, a leading edge in key new technologies including nuclear fusion and nuclear SMR’s, the policy freedoms that Brexit gives us, imminent accession to the CTPPP Asian trading bloc, and enviable “soft power” – and we are going to need them.
Robert Lee November 7th, 2024
*Measured by the M4x money supply series
**The Bank plans to sell £100bn gilts in the next year, on top of the (minimum) £300bn gilt issuance required to finance the budget deficit plus gilt redemptions. The Bank should cancel its bond selling programme immediately.
***There are significant doubts about the credibility of this estimate, so actual revenues may well fall short of this figure. They certainly will if the economy is significantly weaker than the OBR forecasts. The Institute for Fiscal Studies also takes the view that the spending estimates for the later years of the period are unrealistically low, implying even higher borrowing or further tax rises.
