The result of the 2010 UK General Election saw the beginning of the era of fiscal austerity. In the aftermath of that election, much was made of a note to the incoming Chief Secretary to the Treasury, David Laws, from his Labour predecessor Liam Byrne. The letter read simply: “Dear Chief Secretary, I’m afraid there is no money. Kind regards and good luck!”.
The new Labour Government faces a similar inheritance. The Office of Budget Responsibility last opined on the fiscal sustainability of the UK government’s position after its Spring Budget. At that point, the now former Chancellor Jeremy Hunt was – barely – on track to meet his government’s two fiscal rules. Even so, in the International Monetary Fund estimates, Hunt’s fiscal path would leave a ‘black hole’ of £30 billion per year of spending required to maintain non-core government services at current levels and so, while the new Prime Minister Keir Starmer has announced his intention to “take the brakes off Britian”, his Chancellor of the Exchequer, Rachel Reeves, has been very fast to warn of the difficult decisions that will need to be made on public finances.
Despite this, the Labour manifesto has promised a modest uplift to the Conservatives’ planned spending path. It is worth noting that even very core services require annual spending uplifts even just to maintain the current level of service. For example, the NHS alone usually requires an annual spending increase of 3-4% over the level of general inflation. This is before accounting for the current environment, with large patient waiting lists and uncertain, but likely elevated, settlements with their staff.
In the Tony Blair era, NHS budgets were increased by 7.1% over inflation to achieve meaningful improvements. Beyond the NHS, much of the same spending pressure pervades different government departments: prisons, justice, local government and defence – as well as areas such as education and water where underinvestment in infrastructure has now created a very significant upfront spending need. All in all, it seems inevitable that fiscal deficits will continue to widen.
Expenditure-driven widening fiscal deficits imply greater excess demand in the economy. Persistent excess demand relative to supply brings inflation. Although commentators speak as though inflation is entirely the central bank’s responsibility, there is little doubt that larger deficits create inflation. One of the main mechanisms by which this inflation becomes more prolonged is the wage-price spiral, where increasing prices create pressure for increased wages to maintain workers’ standard of living, which are then in turn passed on into even higher prices. To this end, we do not know what the next increase to the minimum wage will be, but there will be pressure for it to be generous when announced this Autumn.
This may not be the end of central government wage increases. Torsten Bell, formerly of the Resolution Foundation, published a book, Great Britain?, just prior to his election as a Labour MP. In this book, Bell suggests that particular sectors, such as social care, should have a Good Work Agreement with a higher wage floor – a premium of, for example £2 per hour over the national minimum wage. It also suggests more protection for workers in areas such as textiles, warehousing, cleaning and security. The details of the new employment laws are unknown and subject to negotiation, but any reduction to labour market flexibility will likely put further upward pressure on wages. This is, of course, in the context of a labour market which is already operating close to full employment, where the latest wage increases have come in at 5.7%.
Put in terms of the Bernanke-Blanchard model of inflation persistence,1 while inflation expectations remain relatively well anchored, wage resistance, which is the desire to use wage settlements to make up for past falls in real wages – is still sufficiently widespread (those doctors!) to suggest that overall wage growth will remain elevated.
The Labour government’s ‘get out of jail free’ card, is supply-side driven economic growth. Supply side growth will, it is hoped, come from planning reform across housing and infrastructure. The combined effect of this plan should, in the government’s view, enable the UK economy to grow at a rate of 2.5% per annum. For context, this is against the OBR’s latest forecast of 1.67% per annum over the coming five years, and 0.7% for 2024. That is all to say that this would be a dramatic increase to the UK’s trend growth rate. It also looks difficult to achieve: for example, the government has announced an ambition to build 1.5 million houses over the next five years. This should definitely increase the numbers of housing starts across the country, but it still clear that capacity – in terms of construction workers, building materials and available working capital – is still far to low to achieve anything near the targets.
The other area of growth is spending to facilitate the transition to net zero. This will now be supported by private sources of finance and co-ordinated by Great British Energy. However, this private capital will need to be regarded and it looks as though the subsidy will come through households’ electricity prices. The original claim that energy costs would fall no longer looks credible at current prices. This spending will add further to excess demand in the economy and whole for now inflation expectations remain anchored, as inflation stays stickier for longer, the less reliable this assumption will be.
Our economic base case is that we expect to see more persistent inflation and wider fiscal deficits – which is a combination that creates a challenging environment for the Bank of England to bring down interest rates further. However, should the Chancellor be successful in achieving supply-driven growth of 2.5% or more, this would come with increased productivity which has the potential to suppress wage-driven inflation and to narrow the fiscal deficit. This is the essence of the gamble on growth.
1For a detailed explanation of the model, see the recent speech by Jonathan Haskel, external member of the Bank of England’s Monetary Policy Committee: UK inflation: What’s done and what’s to come.
Peter Spiller, Chief Investment Officer and Emma Moriarty, Portfolio Manager at CG Asset Management.
