Simon Nixon’s

Political
Economy

Rachel Reeves:
Between a Rock and a Hard Place

It’s not a fashionable thing to say, but I have quite a lot of sympathy for Rachel Reeves.

The Chancellor has endured a torrid first 11 months in office. It is almost impossible to find anyone in politics, the media, business, or finance who has a good word to say about her stewardship of the economy.

Recent data is hardly encouraging. Economic growth in April was much lower than forecast, 10-year bond yields are now higher than under Liz Truss and well above those even of Greece, and there has been an unexpected rise in unemployment.

Reeves’ polling is plumbing depths reached by Kwasi Kwarteng, architect of Truss’ infamous mini-Budget.

Her unpopularity is partly self-inflicted and she is paying the price of Labour’s original sin: the decision to rule out most tax rises ahead of last year’s election. That may have been electorally understandable but it was economically dishonest. In their cynically reckless pursuit of pre-election tax cuts, the Tories had given up any pretence at responsible government, ducking decisions that left Britain’s public services and infrastructure in crisis. But Reeves’ attempt to extricate herself from this trap, by declaring to have discovered a fiscal ‘black hole’ that she chose to fill by scrapping the winter fuel allowance for some pensioners and raising the rate of national insurance contributions for employers, has proved politically toxic.

Nonetheless, much of Reeves’ unpopularity reflects what appears to be an almost wilful denial in much of the public debate about the dire predicament that Britain is in.

One only needs to look at what the markets are telling us. Since the Truss debacle, the UK has had to pay a substantial premium over other G7 countries to borrow in the bond markets. In other words, it has to pay a higher rate of interest on its gilts than it normally would. A similar message is being sent by the stock market where, since Brexit, UK shares have traded at a huge discount to European and US shares – just half the multiple of earnings of US shares, according to Goldman Sachs. That is why British companies are deserting London for New York.

This lack of global investor confidence in UK assets is not just a drag on growth. As things stand, the Government is paying more on debt interest than it does on defence or education.

It is also a sword of Damocles hanging over the economy. When Reeves invokes the spectre of Liz Truss at every opportunity, it is not just party politics, or because she is a closet austerity fetishist, but because the risk to Britain’s financial stability from the bond vigilantes is real.

Unlike America, which is partly insulated from the consequences of Donald Trump’s crackpot tariff policies by its status as issuer of the world’s reserve currency – or the Eurozone, the borrowing costs of which are in effect capped by the European Central Bank – Britain is on its own.

Reeves’ hope was that the incoming Labour Government, by promising political stability in place of Conservative chaos and fiscal responsibility underpinned by tough fiscal rules, could restore investor confidence in UK assets. Removing the risk premium on gilts and reducing the discount on UK shares would bring down government interest costs, lower private sector borrowing costs, and encourage international investment to flow back into the private sector.

But nearly a year later, there is little sign of any significant shift in sentiment. Instead, her task has got harder. Thanks to Trump’s trade wars, which have pushed up longer-dated bond yields globally while dampening growth prospects, the UK is even more vulnerable.

The Chancellor’s Gamble

The reason for this continued lack of market confidence in Britain was highlighted at the recent Bank of England Watchers conference in London. Investors fear that the UK is vulnerable to ‘fiscal fatigue’ – that its political system does not have the patience and persistence to bring down a debt burden that now stands at close to 100% of GDP and which, even on the Office for Budget Responsibility’s March forecast, will barely have come down by the end of the five-year forecast period. What’s more, that forecast was based on growth and interest rate assumptions that already look optimistic.

Recent events suggest that the markets are right to be sceptical.

Reeves herself has adopted a broadly sensible strategy to running the economy, winning plaudits from the International Monetary Fund. To reassure the bond vigilantes that Britain was serious about getting its deficit and debt under control, she committed not to borrow to fund day-to-day spending during the next three years. Meanwhile, to give herself some chance of juicing some growth, she set fiscal rules that would allow her to borrow for public investment. The Chancellor’s gamble was that the markets would be willing to look through the extra borrowing in the expectation of higher growth in the future – and, of course, that this higher growth would materialise.

Reeves put the meat on the bones of this strategy when she announced the outcome of her spending review on 11 June. Day-to-day departmental spending is to be squeezed, rising by just 1.2% in real terms during the next three years, with the biggest rises going to defence and health, leaving most other departments flat.

On the other hand, the Chancellor pushed on with a £113 billion public investment spree, with much of this going into growth-friendly priorities such as housing, clean energy, and transport. Even within the departmental spending plans, there was an emphasis on capital projects: much of the increased defence spending will go on equipment; there was money for new school-building, new prisons, and new government-owned asylum facilities to relieve spending on hotels.

When Reeves invokes the spectre of Liz Truss at every opportunity, it is not just party politics, or because she is a closet austerity fetishist, but because the risk to Britain’s financial stability from the bond vigilantes is real

Yet, the moment that Reeves sat down, the questions began as to whether she could stick to her spending plans.

Is it sufficient to raise defence spending only to 2.7% of GDP when NATO is about to set a target of 3.5%? The Institute for Fiscal Studies has pointed out that the 3.1% real terms increase in health spending is less than the 3.7% average increase under both Labour and Conservative Governments in recent decades and may not be sufficient to bring waiting lists back down below 18 weeks by the end of this Parliament. Even the essentially flat spending settlements for many departments hinged on Reeves’ expectation of £14 billion of efficiency savings that many believe to be highly speculative.

Meanwhile, market confidence in her ability to stick to her plans has inevitably been shaken by her U-turn on the winter fuel allowance. Those concerns are heightened by the fact that the Government is now under pressure to agree to much bigger increases in welfare spending in the form of the scrapping of the egregious two-child benefit cap.

Indeed, to the extent that the Government has any chance of being able to increase departmental spending without recourse to tax rises, it hinges on being able to find savings. The health and disability benefit budget, which has grown by 45% since the pandemic and is forecast to hit £100 billion by the end of the decade compared with £66 billion last year, is an obvious target.

Yet as Reeves has already learned, the public is simply not ready to accept any cuts to welfare spending, or indeed, much else.

The Unhelpful Rise of Reform

The biggest beneficiary of Labour’s winter fuel allowance debacle has been Nigel Farage’s Reform UK, the fantastical economic plans of which include £80 billion of tax cuts.

At the same time, the Conservatives and the right-wing media demand much bigger rises in defence spending without saying how they think it should be paid for. The obvious answer is that Reeves will need to raise taxes again, perhaps by a lot.

But not only will that further sap growth, making it even harder to reduce debt, it will also leave the Labour Government even more vulnerable to accusations of broken promises – exactly as the Tories intended.

That is more than just a political headache for Labour. Ominously for Reeves, Reform’s success in recent elections has started to catch the eye of international investors who are asking how the party’s control of local councils might affect Labour’s investment plans and whether Reform has any chance of being in the next government.

The reality is that the better Reform does in the polls, the harder it becomes to shift the perception that Britain remains politically unstable and remove the stigma that hangs over UK assets.

Rachel Reeves’ misfortune is to be the teller of hard truths in a country only interested in easy answers.

Simon Nixon writes the ‘Wealth of Nations’ newsletter on Substack. He was previously Chief Leader Writer at The Times, and Chief European Commentator at The Wall Street Journal