Labour’s £10 Billion Crisis Bill Just the First Fiscal Challenge

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(Bloomberg) — Britain’s Labour Party is back in government for the first time since 2010 and has promised to hit the ground running with its plan to fix the economy. First it needs to find the money.

On some problems, incoming Prime Minister Keir Starmer may try to play for time by pushing out big decisions to next year. But many crises are so acute there’ll be no choice but to tackle them immediately. In particular, a series of tricky short-term decisions await on public sector pay, fuel duties, and healthcare and prison funding.

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Resolving those would cost as much as £10 billion, official forecasts and think tank calculations show. Fixing the public services long-term will need another £20 billion or more, according to the International Monetary Fund. 

The question is how new Chancellor of the Exchequer Rachel Reeves can do that when the debt ratio is close to 100%, trend growth is anemic and the tax burden is the highest in decades. 

Labour won a near-record number of seats in Thursday’s election as the Conservatives slumped to their worst ever result.

As well as addressing mammoth problems that have grown over years, Starmer and Reeves face the additional challenge of keeping onside a public that voted for change and won’t have much tolerance for bad news. 

During the election campaign, the Institute for Fiscal Studies think tank accused both parties of a “conspiracy of silence” over the painful decisions that need to be taken.

‘No Money’

In 2010, Labour’s last Treasury team left the incoming government a note saying “I’m afraid there is no money.” The situation facing Reeves, Britain’s first female chancellor, is similarly bleak. Depleted finances, huge bills to fix creaking public services and taxpayers who just can’t take any more.

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The capacity for markets to bankroll further spending may be limited, with the UK already planning to raise more than £277 billion from bond investors this fiscal year, one of the largest targets on record. And still fresh is the memory of Liz Truss’s disastrous premiership in 2022 and the bond-market fallout from her budget plans. 

Strategists at UBS Group AG see continuing pressure on UK bonds — particularly longer-dated debt — given lingering fiscal concerns.

That said, markets have been remarkably sanguine about the prospect of a Labour government. Gone are the anxieties about skyrocketing taxes or nationalization that’s haunted previous party campaigns; instead, investors see an end to the political tumult of recent years. Volatility across stocks, bonds and foreign exchange has fallen to near multi-year lows and UK assets rose in the wake of the result.

“Reeves has so far been cognizant of the mistakes made by the Trussonomics experiment and has no intention of spooking the gilt market,” said Craig Inches, head of rates and cash at Royal London Asset Management. Still, given Labour’s spending plans and pledge not to raise taxes, “there is a likelihood that in her first Autumn statement the new chancellor could be coming cap in hand to the gilt market for some additional cash.”

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Out of the Blocks

Labour’s early weeks will be peppered with policy announcements, including on employment rights and new state institutions like GB Energy and the National Wealth Fund, before the big fiscal event: the budget in September or October.

That will be the first real test. It will be too soon for the economic growth Starmer hopes can deliver the funds he desperately needs. Instead, Reeves will find herself trapped by her fiscal rules, her aspiration not to raise the tax burden and urgent calls on the public purse.

To bypass the problem, Thomas Pope, deputy chief economist at the Institute for Government, expects a short-term fix that pushes out the tough decisions. 

Reeves is likely to announce a one-year rollover spending review that provides a “bump in spending” for services that’s then withdrawn to ensure her key fiscal rule that debt is falling as a share of GDP in the fifth year of the forecast is met. 

“This might give them a bit longer to see if the economy improves,” Pope said. “More cynically,” he added, it would give Reeves “years of tighter spending plans that they can pencil in before the debt rule binds.”

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The Tories used the same ploy for the election year, something the Office for Budget Responsibility, the government’s independent fiscal watchdog, described as a “fiction.” Labour declined to comment, but a person familiar with the party’s thinking said no decision has yet been made on the spending review.

Ben Nabarro, chief UK economist at Citigroup Inc., agrees that Reeves is likely to delay longer-term plans for departmental budgets until next year in the hope that growth picks up.

By then, the trajectory for interest rates may also be more favorable. If borrowing costs are half a point lower, Labour would have between £5 billion and £10 billion more spending headroom. 

“I would call it ‘playing for time’ rather than ‘extend and pretend’,” Nabarro said, referring to a strategy sometimes used by lenders on bad loans. 

What Bloomberg Economics Says…

“Absent a surprise growth burst or a big drop in interest rates, more money will need to be found from somewhere to ensure the debt burden falls — a target Labour has said it will commit to.”

—Dan Hanson, Ana Andrade, Niraj Shah. Click here to read the UK REACT.

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Whatever Reeves does, she’ll need to find a lot of money in that first budget. One big early decision will be on public sector pay as Labour attempts to end the strikes that have plagued the country.

Official pay review bodies have submitted their recommendations. Should those match forecasts for private sector pay, the settlement will cost about £6 billion more than currently budgeted, according to the IFS.

Money is also desperately needed for the justice system, with prisons close to overflowing. Last year, the Ministry of Justice had to tap the government’s emergency reserves – usually a last resort – and redeploy infrastructure funds into day-to-day operations to keep running.

At the budget, Reeves will have to decide whether to freeze fuel duty as the Tories did for years, at a cost of almost £5 billion. Starmer has said he’s “very sensitive” to the impact on motorists, aware that any hike would create a huge backlash.

Then there are general needs: a 3.6% above-inflation increase in funding for the National Health Service to beef up staffing and get started on clearing record patient waiting lists, additional money for Ukraine, top-ups for stricken local authorities, and compensation for victims of the infected blood and the Post Office Horizon scandals.

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Nabarro said the party may have to raise up to £15 billion in taxes in the budget to cover essential spending pressures, possibly through lower relief on pension contributions and higher capital gains and inheritance tax.

Alternatively, Barclays and Citi have suggested tweaking accounting rules around the Bank of England’s quantitative easing program to save as much £20 billion a year in debt interest.

Whatever Reeves decides in her first budget, “the weakness of the underlying fiscal picture means stark near-term choices,” Nabarro said.

—With assistance from Andrew Atkinson, Alice Atkins, Greg Ritchie and Gina Turner.

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