The trigger for her problems had been a debut “fiscal event” from a confident newly installed chancellor, eager to a kickstart a new era for the British economy.
Instead Kwasi Kwarteng’s ill-fated mini Budget spooked the markets and led to a surge in interest rates and the cost of mortgages.
Now some have expressed fears that history is about to repeat itself – that another bold new Chancellor could be spark a similar train of events by ripping up existing rules on government borrowing in her debut Budget on October 30.
Rachel Reeves is poised to overhaul these “fiscal rules” (see box) to allow the Government to spend more money on long term investments.
There are a number of ways she can do this, and a source close to the Chancellor has confirmed to i that she is planning what could be one of the most controversial options – changing the government’s definition of government “debt”.
There has been plenty of signalling that something like this could happen – in Reeves’ party conference speech last month, she told Labour activists: “It is time that the Treasury moved on from just counting the costs of investments, to recognising the benefits too.”
Danger ahead
But advance warnings can cut both ways. And what may have been intended as sensible pitch rolling for the change ahead has also prompted alarming alerts about the problems it could trigger.
The risk is that changing the fiscal rules worries the markets and results in real world consequences for voters in the form of higher interest rates and more expensive mortgages.
As former Conservative Chancellor George Osborne said in his podcast this month: “What the British Government has to do is go and convince international markets, people all over the world, institutions to invest in British Government debt, and they’re not just going listen to ‘Oh, that’s fine they’ve changed the definition’, they’re still going to ask the same question they were asking before the Budget, which is, ‘Does this all add up?’
Treasury veterans Ed Balls and George Osborne have been outlining the risk Reeves faces in changing the fiscal rules. (Photo: Stefan Rousseau/PA Wire)
“And we had a very recent episode on Liz Truss when it was shown that this sort of fear that the bond market can turn on Britain was not a theoretical risk, as I was often told as Chancellor… The Truss premiership showed the bond market is real, and when it turns, it can be fatal for the Government politically and economically.”
Similar warnings are coming from the financial world. Nigel Green, chief executive of deVere group, a global financial advisory firm, said last week: “If Reeves doesn’t tread carefully, we could see a repeat, albeit to a lesser degree, of the panic that followed Truss’s mini-Budget.”
Meanwhile Ben Nabarro, Citibank’s chief UK economist, who has worked with the Institute for Fiscal Studies’ assessment of Reeves’s Budget options, has suggested there could be a “buyers’ strike” – a run on the bond markets – depending on how such changes are introduced.
The markets have already been moving. Green pointed to how the interest rates that the UK government pays on its debt had “surged from 3.75 per cent to 4.2 per cent” in a measure of falling investor confidence ahead of the Budget.
Former Labour shadow chancellor Ed Balls makes a similar point through a comparison with US interest rates which are usually higher than the UK’s.
“The one period when UK interest rates jumped markedly higher than America’s was during that Liz Truss period,” he said on his podcast with Osborne.
‘A market wobble is happening already’
“That was the Liz Truss market wobble. In the last few months, we’ve started for the first time again to see UK long term interest rates go higher than America’s, since the middle of the year, since the general election… we’ve had a bigger rise in the markets demanding a high interest rate in Britain than the other big G7 economies this year.”
He believes concerns over Reeves changes to fiscal rules could be a factor in that rise. “There is a bit of that market wobble nervously happening already,” he said.
How Truss and Kwarteng’s mini budget ended in disaster
Shortly after she took over as Prime Minister in September 2022, Liz Truss and her Chancellor Kwasi Kwarteng announced a package of tax cuts worth £45bn a year.
The measures in the “mini Budget”, which included lowering income tax and corporation tax, were not balanced out by lower public spending – in fact, they came alongside a promise to subsidise household energy bills after the spike in wholesale gas prices caused by the invasion of Ukraine.
Liz Truss and Kwasi Kwarteng were close friends and allies until Mr Kwarteng was sacked following the disastrous ‘mini-budget’ Photo by Leon Neal/Getty Images)
Truss had already shown a disregard of economic orthodoxy: she sacked the Treasury’s most senior civil servant, Tom Scholar, and refused to commission a “scorecard” on her tax and spending plans from the Office for Budget Responsibility, which would have shown the likely effect on the public finances over the medium term.
Within hours, the markets started reacting badly to the mini Budget. Government borrowing costs increased, while the pound lost value against other major currencies. Truss and Kwarteng were unrepentant, and promised further tax-cutting measures to come.
It became clear that the Bank of England would soon have to raise interest rates in order to ensure that UK Government debt remained attractive to investors – triggering a meltdown in the mortgage market, with borrowers reluctant to offer loans amid the turbulence.
Gilt yields – the interest rate that the Government must pay on its debt in international markets – kept spiralling upwards, driven partly by a poorly understood part of the market called liability-driven insurance (LDI) which meant that some firms affected by the turmoil had to keep selling bonds to raise cash, adding to the chaos.
It was only after the Bank of England stepped in that the situation began to calm, helped by Truss’s promise to reverse some of the measures – but she was still forced out of office within weeks, having lost the support of Conservative MPs.
She has since blamed regulators for failing the spot the problems in the LDI market, claiming that this relatively technical issue was responsible for the majority of the markets meltdown.
And she was unlucky with the timing: borrowing costs were already rising around the world, and traders had been taken by surprise at the failure of the Bank of England to raise rates earlier in order to deal with inflation.
But most economists agree that the chaos was ultimately self-inflicted, given the failure of Truss and Kwarteng even to pretend they had a plan to balance the public finances in the foreseeable future.
He suggested the Chancellor was aware of the dangers, given her promise to impose “guardrails” on borrowing, and added: “If she’s got guard rails within her fiscal rules that tells you that there’s a bit of concern, and that concern is undoubtedly firmly reflected in the financial markets.”
Benjamin Caswell of the National Institute of Economic and Social Research (Niesr) told i: “There is a wait-and-see approach from a lot of investors at the moment, they want to see what gets announced specifically.”
How the rules could change
The Government’s self imposed fiscal rules are set by the Chancellor and then used by the Office for Budget Responsibility (OBR) as a way of judging the Budget.
Labour has set out two of them. The first would be: “The current budget moves into balance, so that day-to-day costs are met by revenues.” Under the Conservatives, the deficit could be no more than 3 per cent of GDP, but there was no distinction between borrowing used to fund current spending and that used for investment.
Labour’s second rule was to be: “Debt must be falling as a share of the economy by the fifth year of the forecast.” On the face of it, this would be identical to the Tories’ guidelines, with the same five-year timeframe in which to bring down the stock of Government debt.
But the definition of that debt could be changed – an option, that a source close to Reeves has confirmed to i she is taking. This is a highly technical area which is the subject of an ongoing debate over how best to account for the Government’s asset, liabilities, spending and revenues
Benjamin Caswell of the National Institute of Economic and Social Research (Niesr) told i that one fairly straightforward option would be to exclude the effects of the Bank of England’s asset purchases and sales from the calculation of the national debt, which currently makes the Treasury more subject to the ups and downs of interest rates. He said: “It is weighing heavily on the Treasury at the moment, and it is tying their hands. If you exclude the Bank of England, you might be able to free up a bit of space.”
Many economists expect the Chancellor to go further in order to raise money which will be spent on infrastructure projects such as green energy, transport links and hospital buildings. Barret Kupelian of PwC said: “We expect less orthodox approaches to be adopted, which are likely to involve amending fiscal rules – recognising the fact that short-term net debt rules put a chokehold on long-term investments. In practise, this will involve recognising some assets on the Government’s balance sheet and netting these off against Government debt.”
This approach is popular on the centre left: the Resolution Foundation has called for debt measurements to be tweaked so that they take into account the value as well as the cost of Government investments in the same way as private companies do – meaning that cash spent on infrastructure does not simply disappear from the balance sheet – and the Labour Growth Group of backbench MPs has issued an open letter backing the policy.
But the more radical the change Reeves goes for, the more she risks spooking the markets.
A worst-case scenario would see the Bank of England forced to increase interest rates again to ensure that UK Government bonds remain attractive to investors – pushing up the cost of mortgage borrowing just at a time when homeowners are beginning to see their expenses fall.
One Treasury veteran warns that the Chancellor cannot not simply rely on the continued goodwill of borrowers, saying: “Rachel Reeves doesn’t have inherent credibility with the markets – it has to be earned and demonstrated.”
Why Reeves is confident
But her inner circle are confident there will be no repeat of the Truss meltdown. A source close to the Chancellor told i: “The reason Liz lost the confidence of the markets is, firstly she slagged off the institutions – by sacking Tom Scholar, sidelining the OBR and so on – and secondly that she borrowed to fund tax cuts without a plan to pay it back. Our fiscal rules are much tougher, and that is why we have got the nightmare around the spending review.”
Tom Clougherty, head of the Institute of Economic Affairs – a free-market think-tank which initially backed Truss’s mini Budget in 2022 – also plays down the comparison between then and now. He insists the importance of detailed fiscal rules is often overrated because they are “basically just a signalling device to show seriousness to the financial markets”. “Fiscal rules are apparently made to be broken,” he said. “All of the Chancellor’s predecessors have fiddled with the rules for political reasons – we shouldn’t expect her to be any different.”
The problem with Truss, he argues, was that in her case “there was no real nod to the rules, they just said ‘we are ignoring them’” – and he thinks the current administration will not make the same mistake.
But there are other risks. Throughout the general election campaign, Reeves repeatedly pointed to the Truss disaster as evidence for why it is important to stick to strict rules. She also insisted that she was “not going to fiddle the figures or make something to get different results”, even if that meant having to hike taxes and/or make tricky public spending cuts.
The upshot is that even if markets take the new fiscal rules in their stride, Labour’s political opponents will make hay with her apparent U-turn. Conservative shadow Treasury minister Alan Mak told i: “Rachel Reeves promised not to – in her own words – ‘fiddle’ the fiscal rules. And in the end it will be the public that pays the price for this with interest rates staying higher and for longer, and mortgage rates hurting families right across the country.”
And other more neutral commentators may question her decision for different reasons. The Institute for Fiscal Studies has warned that, while changing the fiscal rules would allow Reeves to borrow billions of pounds more, it will have no effect on the underlying realities of the public finances.
The think-tank said recently: “If the Government wants to borrow more and spend more, it would ideally make the case for doing so on its own terms, rather than hide behind fiscal jiggery-pokery.”
And if the markets turn, and plunge Reeves into a repeat of the crisis that she has made it her central mission to avoid, then such criticism will only be the start of her problems.
