The Labour party’s emphatic victory in the UK election of July 4th is a cause for celebration for progressives around the world. It was a rejection of fourteen years of failed neoliberal policies that have left Britain’s public services stretched to breaking point, the largest drop in household living standards on record and shameful levels of poverty and homelessness. 

Keir Starmer’s new government faces enormous challenges but it has made an ambitious start. Eye-catching policies in the King’s speech include the creation of a new, publicly owned national energy company (Great British Energy) and a National Wealth Fund (NWF) to invest in major decarbonisation projects, the lifting of a ban on on-shore wind, the phased in nationalisation of the railways, ambitious plans on home building and major improvements to workers’ and renters’ rights. The state interventionism on display goes beyond the ‘third way’ of Tony Blair’s New Labour that the Labour leadership appeared sometimes to be modelling itself upon.

But there is a catch. Whilst it has broken with the neoliberal consensus on industrial policy (or lack of), Labour remains captured by defunct neoliberal thinking on fiscal policy. Rachel Reeves has adopted two ‘fiscal rules’: first, that it should borrow only for investment and not for day-to-day spending; and, secondly, inherited the Conservatives’ widely criticised rule that overall debt should be falling as a percentage of GDP over a rolling 5-year cycle. 

So determined are Labour to embed in the electorate’s mind the idea that they are the fiscal ‘grown-ups in the room’ that they have tabled a new ‘fiscal lock’ rule

Labour has put these rules at the centre of their effort to recast itself as the party of ‘fiscal credibility’, in contrast with the Liz Truss ‘mini-budget’ of September 2022 that led to a temporary collapse in sterling and sharp rise in government bond yields. So determined are Labour to embed in the electorate’s mind the idea that they are the fiscal ‘grown-ups in the room’ that they have tabled a new ‘fiscal lock’ rule that will ensure any major and long-term change in tax or spending policies will be evaluated by the independent Office of Budget Responsibility (OBR). This is the spending watchdog introduced by the previous Conservative Chancellor George Osborne in 2010 when the Tories were playing the same fiscal credibility card against Labour after the 2007-08 Global Financial Crisis.

This strategy may have helped Labour win the third biggest majority in British political history. But it leaves Labour in a difficult position now that they are in power. The combination of sluggish growth and the higher interest rates on government debt that followed the inflation of the last few years mean the 5-year falling debt-to-GDP target will be unobtainable unless the economy grows at around 3 times this year’s expected rate according to a recent IMF analysis.

If that is not achieved, the only option is further painful cuts to public investment and public services or to engage in major tax rises. On the latter, Labour have ruled out any rise in income tax, Value Added Taxation (consumption tax), and National Insurance which together make up 75% of the tax intake.

Only one country has achieved anywhere near the 2.5% per annum levels of growth Labour needs to hit its debt-stock fiscal rule since the Covid pandemic: the United States. And the US pushed through by far the largest fiscal expansion of any high-income country over the past few years. Its government deficit for 2021 was almost 9.4 per cent of GDP, more than double the level of the UK and Eurozone, and included a $2.2trn of stimulus for households that led to swift recovery in consumer spending. This was followed up by massive investment in industrial policy, including Joe Biden’s $369bn Inflation Reduction Act and $40bn Chips Act which have led to investment booms. 

The new Chancellor Rachel Reeves’ first major pronouncement on fiscal policy at the end of July claimed that there is a £22bn “black hole” in the public finances. This was caused by the previous government deliberately understating its spending and by the fact that Labour has, wisely, agreed to above inflation pay rises for public sector workers. In response to this ‘emergency’, Labour announced plans to cut investment in long planned infrastructure, reduce winter fuel payments to better-off pensioners and abandon a planned cap on social care payments, alongside hints at tax rises further down the road.

Gambling on private-sector driven growth

These cuts and tax plans suggest Labour is very serious about hitting its debt-to-gdp rule, even if this may dampen long-term growth. This would be another step in the wrong direction after the party abandoned its most ambitious fiscal policy – its £28bn-a-year borrowing plan to fund green investment plan – which was dropped months before the election under pressure from the Conservatives. In fact, its manifesto committed to just £3.5bn in additional borrowing to finance the National Wealth Fund and Great British Energy, alongside an additional £8.5bn in tax rises and reforms.

Labour has argued it can achieve much higher levels of growth by leveraging private finance for capital investment. Indeed, this is the primary aim of the NWF which aims to crowd in £3 for each £1 it invests. But the UK has been near the bottom of the capital investment league tables in high-income economies for the last two decades. It is not realistic to expect a huge short-term shift, particularly given that high interest rates mean investors will expect higher returns from potentially risky green infrastructure projects. When it comes to homebuilding, as the previous government’s own investigation discovered, the UK’s oligopolistic private development sector has no incentives to build out a rate that would depress house prices – and thus profits – in the regions they operate within. 

Even if private finance is more effectively levered in, a ‘de-risking’ strategy which outsources the pace and direction of green transition infrastructure or home-building to the private sector carries with it its own set of risks, including democratic ones if large swatches of vital public infrastructure end up being owned by asset managers. Previous UK governments’ experiences with the failed Private Finance Initiative have shown the limits to such an approach. 

Labour needs tens of billions of pounds now for investment in education, health, social care, prisons and local councils after 14 years of austerity.

Moreover, even if it happens, capital investment generates growth in the medium-to-long term. Labour needs tens of billions of pounds now for investment in education, health, social care, prisons and local councils after 14 years of austerity. A well-educated and healthy workforce is, rather obviously, fundamental to economic growth. More than half a million people left the UK workforce between 2018 and 2022, mainly due to the effects of the pandemic, which overwhelmed the health sector. Labour is missing a strategy for rebuilding not just the physical, but also the social and health infrastructure of the country. 

Institutional realities 

Labour’s fiscal rules are based on flawed economics and a wrongheaded understanding of the UK’s public financing institutional arrangements. The government does not need to raise money from either taxes or borrowing prior to spending. As myself and co-authors have demonstrated in our ‘Self-Financing state’ paper, whenever the UK government spends it creates new money. The government has what is akin to an interest free overdraft at the Bank of England with no technical limits. When the government “spends”, this account is debited and the same amount of new money is credited to government departments by the Bank, appearing as new deposits in government departments’ commercial bank accounts. These arrangements are codified in law that goes back to 1866.

Taxes are an important tool for ensuring the State’s monopoly control over the currency, for reallocating resources and dampening inflation, but they do not directly finance government spending.

What then is the role of taxation and public borrowing? Revenues from taxation accumulate into the same government accounts and reduce the size of the Consolidated Fund overdraft. Taxation reduces the government’s liabilities to the Bank of England, reversing the money-creation process and reducing the money supply. Taxes are an important tool for ensuring the State’s monopoly control over the currency, for reallocating resources and dampening inflation, but they do not directly finance government spending.

Borrowing is equally poorly understood. Prior to the programme of quantitative easing (QE) that began in 2009, bond issuance was designed primarily to support monetary policy. Government spending creates new money and liquidity (reserves) in the banking system which can affect the ability of the central bank to pass through its target interest rate. By issuing bonds, the state withdraws liquidity from the banking system, neutralising this impact. Indeed, the UK’s Debt Management Office has in place a “full-funding” rule which means that any outstanding balances in the Consolidated Fund are cancelled out by debt issuance or selling bonds into financial markets.

However, the QE programmes of the past 14 years have seen the banking system flooded with liquidity. This led the Bank of England to pay interest on reserves held by banks to help target the interest rate effectively and made changes in government spending less important to monetary policy. The FFR thus looks somewhat anachronistic. The main function of government debt today is arguably to provide the non-bank financial sector with a secure store of value and source of collateral, with government debt instruments being the most desirable, safe, interest-bearing assets available due to the state’s inherent creditworthiness. 

Targeting real resources and managing inflation

Britain thus does not face solvency, liquidity or market risks in the way a household (or indeed a firm) does. The government can always finance its own spending and indeed always pay interest on borrowing in its own currency as in both cases it creates money. Rather, the main constraint on UK government spending is the availability and mobilisation of real resources. Inflation will result if new money is spent on already fully utilised resources which cannot absorb it. 

Sudden announcements of increases in government spending without a plan for how such spending will be absorbed into the economy will be perceived as inflationary by investors. This is exactly what happened during the mini-budget when, with inflation at 10% and rising and the Bank of England ramping up Quantitative Tightening (selling bonds into the market), the Truss government proposed £45bn worth of tax cuts funded by bond issuance. Investors feared the real value of their bonds would fall and sold them off, setting in motion a self-fulfilling cycle of currency depreciation and further falls in yields. This had nothing to do with investors’ fears about the government’s solvency or capacity to repay its debts and everything to do with fears about the future value of their assets. As it turned out, once the Bank of England stepped in with more QE to rescue the flailing pensions sector most exposed to the volatility in long-term bond yields, sterling and the UK’s bond ratings quickly returned to normal. 

In contrast, a targeted fiscal expansion aimed at boosting healthcare to bring back into the workforce some of the hundreds of thousands of people who left it during Covid as well as investing in green infrastructure, including scaling up clean energy production but also energy efficiency home retrofit, are clearly policies that would increase the country’s productive capacity and resilience to future inflationary shocks. Furthermore, with inflation now back down to 2% and the bank of England finally cutting interest rates, Labour is in a strong position to embark on such an expansion. 

Labour needs to shift people out of less important or damaging sectors of the economy and into its priority areas to enable the structural economic change required to meet the UK’s ambitious climate targets.

Further real resources could and should be freed up by much more ambitious reforms to current tax and subsidies. Labour needs to shift people out of less important or damaging sectors of the economy and into its priority areas to enable the structural economic change required to meet the UK’s ambitious climate targets. Reducing subsidies for fossil fuel sectors and raising taxes on them to speed up their retirement and the transfer of workers into green sectors – for instance offshore oil to offshore (and onshore) wind – is one obvious requirement. Taxes on environmental bads like private jets, environmentally and health-damaging foods, and on wealth more generally could also help reorient investment in a more productive direction and stimulate sustainable growth. 

With its huge majority, Labour has a massive opportunity to become a leading light of 21st century social democracy and provide an alternative to the populist far right movements gathering steam in both Europe and the US. It has five years to demonstrate the potential of the state to transition to a fairer and sustainable economy. To do so, it must abandon its self-imposed fiscal straight jacket in the same way it has rightly abandoned much of the rest of the policy framework inherited from the Conservatives. 

 

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Josh Ryan–Collins is Professor in Economics and Finance at University College London Institute for Innovation and Public Purpose. His books include Why Can’t You Afford a Home (Polity: 2018), Rethinking the Economics of Land and Housing (Zed: 2017), and Where Does Money Come From? (NEF: 2012).