Merlin Weekly Macro: Reeves in fiscal fantasy land?

After a prolonged spring drought, rain-dancing gardeners and farmers have seen their prayers answered with some much needed early summer rainfall. Meanwhile, in No. 11’s back garden, Rachel Reeves is still dancing hard, praying for good economic news to fall from the heavens. It has not arrived yet. That she is a large part of the problem seems to have passed her by.

Elusive growth: who knew?

The latest data remains largely arid and free of green shoots. The April numbers released this week saw the UK economy shrink 0.3% against March; after a surprising burst of enthusiastic activity in February, it remains to be seen whether two months of deceleration leading to decline is becoming a trend. Further evidence supporting a slow-down is found in the latest unemployment data: the jobless rate ticked up to 4.6%; simultaneously job vacancies have continued an unbroken series of monthly erosions, standing in April at 736,000, down 3.2% from March and 132,000 (15.3%) lower than 12 months ago. Allowing for the covid-related spike in 2020/21, the 10-year unemployment chart is a graceful U-shaped curve with a defined low-point of 3.6% in August 2022. The last time we saw 4.6% was in April 2017 when on the firm downward trajectory from 8.5% in 2011 and the aftermath of the Global Financial Crisis.

The economy is struggling to maintain growth. The employment market is deteriorating. The two go hand-in-hand. Rachel Reeves’s Budget last October delivered a big hike in employment taxation effective from the beginning of April. In Angela Rayner’s imminent bill, all the frictional costs associated with her determination to bolster workers’ employment rights will encroach further on competitiveness. It is hardly surprising that businesses have been taking a long, hard look at their wages bills and the number of staff on their books.

Shaking the Magic Money Tree

This week saw Reeves publish her Spending Review, the strategic plan ranging from day-to-day running cost limits to long-term capital investments in every one of the government’s spending departments. It was supposed to be the detailed allocation of resources within the envelope of the fiscal limits defined in last October’s overarching framework. One should have followed the other in a logical sequence.

As we know, the fiscal headroom that Reeves thought she had built into her assumptions over the life of the current parliament had evaporated by March and the Spring Statement. From this week’s announcements of significant Treasury largesse and £113bn of capital spending over the remainder of the decade, you would be forgiven for thinking there had ever been a problem, let alone a ‘£22 billion black hole’ crisis which required scraping the bottom of the barrel to find £1.5 billion and the confiscation of the winter fuel allowance to plug the gap.

The self-imposed fiscal rules to which Reeves is working are pragmatic and sensible: use borrowings raised through the markets to fund capital investment; keep the aggregate of day-to-day departmental running costs within the confines of tax income. Invest long-term capital; balance the books at the operational level.

Capital Asset Pricing Model: the theory….

The rationale for borrowing to invest is sound but depends on a foundational premise: that the rate of return on the investment exceeds the cost of capital. In turn, which depends on two factors: the theoretical economics of the project and the actual efficiency of the application of the capital. At the risk of being technical, the prospective internal rate of return on the project’s capital can almost be whatever you want it to be, depending on the discount rate applied to future cashflows to arrive at the net present value (much more useful is to flex the discount rate and the operating assumptions to establish an indicative range of outcomes: a sensitivity analysis, rather than relying on a single numerical output). Capital efficiency (implementation, timing) is subject to the effectiveness of project management and the extent to which factors beyond the management’s control might put obstacles in the way (a good example, finding large and historically important plague pits in east London during the Cross Rail excavations). The more friction, inefficiency and disruption, the greater the likelihood of a sub-optimal financial outcome.

…and the practice

The history of major government capital projects in the UK is littered with such euphemistically termed ‘sub-optimal financial outcomes’: Cross Rail for one; to which add HS2, NHS Track & Trace, a brace of aircraft carriers, Sizewell C, to name but a few. This is not historical: it is still happening today. As well as nuclear energy, the government is committing more resources to renewables, in particular offshore wind projects; the truth here is that the incremental taxpayer-funded capital is a government backstop that props up projects whose commercial rate of return is not only inadequate but unviable. Rationally, that is a misapplication of capital.

In plain English rather than economist-speak: even if the project fulfils a social purpose (in this case generating electricity), if the interest rate and the project costs are too high and the return too low and you’re not very good at managing projects, financially it’s a dud. Investment in infrastructure and services is necessary; that goes without saying. Society and the economy need to progress. But the prerequisites are threefold: 1) it must be affordable; 2) it must demonstrably improve outcomes; 3) it must be efficient.

Irrational economics

The biggest ‘winner’ in Reeves’s spending spree is the NHS, due to benefit from £17bn of incremental spend in real terms over four years. At the end of 2023 it accounted for 8.4% of GDP (£225bn); with 1.5m full-time-equivalent staff it is not only the biggest employer in the UK but the biggest in Europe, indeed is believed to be one of the biggest ten employers in the world. Despite the percentage of GDP allocated to health having doubled since the Millennium, the empirical evidence points to a declining service. It has not only delivered diminishing returns but negative ones. Bluntly, it is a voracious monster which will devour every pound note thrown its way to no discernible benefit.

The question taxpayers and patients (many of whom are the same people) should be asking is simple: does spending yet more money on the NHS provide the solution or perpetuate the problem? 25 years of similar initiatives point to the latter. The riposte is as logical as it is irrefutable: if more of the same makes the situation worse, what do we need to do differently to make it better, both in terms of patient experience and value for money to the taxpayer? Neither the Chancellor nor the Health Secretary has a satisfactory answer but the extra money is being committed anyway.

The same argument and principles can be applied to every government spending department in terms of cost/benefit.

Growth: the ephemeral get-out-of-jail card

The fear is that her sums do not add up. Reeves is hoping that economic growth will bail her out. It is not impossible but it is a tall order. Self-evidently, as illustrated perfectly this week, her problem on that score is that she does not control growth.

The May forecast from the OBR is that by 2029/30, public sector net debt will total £3.4 trillion, a 26% increase on the £2.7 trillion in 2023/24. The UK economy is currently calculated to be worth £2.6 trillion; for the debt/GDP ratio to be contained at today’s rate hovering around 100%, the economy needs to expand in real terms by at least a quarter in five years. It took exactly 20 years to grow by a quarter to where it is today. Debt interest has broken through the £100 billion pa mark, up from £45 billion in 2019, and was projected to reach £122 billion by 2029/30, even before this Spending Review. By then the UK will be spending more on debt interest than the aggregate of the Defence, Justice, Home and Foreign Office budgets combined. Debt interest of this magnitude is a big economic ball and chain.

October: another trip to the well

If the spending review is the debit side of the ledger, the forthcoming October Budget will be the credit column that determines whether the books balance through tax revenues. Remember, it was the 2024 Budget which was supposed to inform the 2025 spending limits; the Chancellor is not supposed to be using the 2025 Budget to plug the gaps and to cover her tracks.

If the capital spend funded by borrowings is already defined and quantifiably large, she cannot afford a head-on clash with the bond markets if the day-to-day operational spend is in deficit too. There is a considerable risk that she may have to come back with more tax rises despite the tax burden already being the highest in eight decades. Rising corporate taxes inhibit investment and employment; higher personal taxes constrain consumption. Neither is going to help the economy grow, certainly not at a rate that is significantly higher than the mediocre average of around 1.5% experienced over the past decade-and-a-half that is needed to keep the national loan covenants in check.

Bucket ideology

It was Churchill who observed wryly, “I contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to pull himself up by the handle”. Rising above the noise of detailed departmental spending, the essential flaw in Labour’s economic plans is an ideological one: through economic centralisation and intervention, it believes that the state is a better allocator of capital than the private sector. The logical extension is that it has a greater entitlement to your capital than you do. Therefore through taxation it will relieve you of what it deems to be any un-earned or unjustified excess and apply it for the greater good. Labour’s manifesto was as explicit about the failure of free-market economics as it was about the redistribution of wealth. We’re watching it in action: the man standing in a bucket, trying to pull himself up by the handle.

As we go to press Israel has launched a pre-emptive strike on Iran’s nuclear and ballistic installations and its military command structure. As if we needed it, it reminds us that the world is a dangerous place. The NATO summit at the end of June is likely to find Reeves and Starmer’s leisurely and underwhelming commitment to defence spending is barely half what NATO will say we need to be doing, and we need to be taking much faster action. If Reeves’s sums are under pressure already, the situation is about to be a whole lot worse if she and the prime minister are forced to find potentially 2.5% of GDP extra to pay for it.

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