Merlin Weekly Macro: A complacent budget courts fiscal crisis

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Nothing to see here! Move on

‘Breathing space’: the new Chancellor’s euphemism for indecision and procrastination. Deferring most of the major decisions into the 2027 Spending Review, this was nothing more than a smoke and mirrors Budget designed not to spook the bond markets. Given the lack of reaction in UK government bond yields, it achieved its aim. John Healey will be pleased. He should not be.

Keir Starmer’ glass was always half empty as Prime Minister: he and his then chancellor, Rachel Reeves, made a point of talking down the economy. With no solutions (at least neither workable ones nor ones acceptable to Labour back benchers), ultimately, they both paid for that pessimism with their jobs. This week, Reeves’s successor John Healey took the opposite tack: he was bigging it up. Optimism in a chancellor is a positive.  However, there is a fine line between optimism and self-delusion. He was working with some very thin material.

In a parliamentary version of Orwell’s ‘Four legs good! Two legs baa-aad!’,  the sheep’s refrain in Animal Farm, Healey punctuated every section of his speech with: ‘Delivered to the British people by this Labour government!’. The faithful on the government benches lapped it up, not least because there was zero in the content that they could possibly disagree with; anything contentious will come in the March Spending Review. Even that pious hope is doubtful.

It was a bravura performance in which he managed to make plodding projections seem quite palatable. An old pro, he remained unforcedly cheerful as Opposition leader Kemi Badenoch efficiently rained on his parade in response. She was in her element, thinking fast on her feet and thoroughly enjoying it. Much more revealing was the countenance of the Prime Minister while Badenoch was tearing lumps out of the government: across the dispatch box Andy Burnham was wearing a stony countenance, an unsmiling grim mask. It reminded me of Rachel Reeves’s first Budget two years ago when under the withering onslaught of an on-fire and feisty Rishi Sunak, her triumphant smiles melted and she suddenly looked hunted. Burnham also looked hunted. He’d been rumbled too and he knew it.

Forget the spin: the OBR gives the unvarnished truth

Whatever Healey’s storyline to the House, the true position is revealed in the Office for Budget Responsibility Economic & Fiscal Outlook Report¹, released to coincide with the Chancellor’s speech. The opening paragraph of the executive summary tells us almost everything we need to know:

‘The UK’s economic and fiscal position remains very challenging. Since 2008, repeated adverse shocks have contributed to persistently weak GDP growth and elevated levels of government borrowing. This has resulted in a sharp increase in government debt as a share of GDP, to a level that is high by both recent historical and international standards.’

The cost of servicing that debt was £39 billion in 2019/20 (1.7% of GDP); the estimate for this year has risen to £109 billion (3.5%); the OBR calculates that by 2031/32 we could be incurring £160 billion (4.2% of GDP) on debt interest. Elsewhere the official arbiter of fiscal probity reports unflatteringly on the tax burden which is projected only to increase: ‘the “tax take” is forecast to increase sharply from 36.0 per cent of GDP in 2025-26 to 37.9 per cent of GDP in 2027-28, surpassing the previous historical high, before then rising more gradually to reach a peak of 38.6 per cent of GDP in 2031. This would be a 5.7 per cent of GDP increase on the pre-pandemic level of 32.9 per cent of GDP in 2019-20.’ There we have it.

For all Healey’s spin, the economic outlook offered by the OBR is underwhelming. Real GDP might just get to 1.25% in the current fiscal year. As Healey points out factually, it is one of the fastest growth rates in the G7. So what? According to PwC’s economists, real global GDP growth will be double that: plenty of other countries are winning market share from us. UK growth then falls away again next year to 1.0%, a half percentage point lower than forecast by the OBR in March. Peaking possibly in 2028 at 1.8%, forecast GDP is expected to subside towards 1.6% by the end of the decade. Bereft of substantive ideas for growth, Burnham seems determined to hitch our cart to Europe’s arthritic, hobbled nag: the EU economy is virtually stagnant and in the event we are accepted back as a member, we will give up all sovereignty over trade policy. How that helps is unclear.

That said, despite a Bank of England interest rate which is likely to rise from its current starting point of 3.75% in response to the inflation pressure, the economy is showing some surprising resilience. Monetary policy is intended to change consumer behaviour as the means of maintaining price stability: despite the significant changes in interest rates since before Covid and allowing for the 2020-2022 short-term GDP volatility created by lockdown, underlying growth has been little affected overall. Governor Bailey must be ruminating with some anxiety at the muted impact of their policy changes in either direction.

A doom loop of domestic stagnation

But if volatility has been dampened, so have activity and productivity. If the OBR proves correct, outside the Covid-hiatus year-on-year real UK GDP growth will not have exceeded 2% in any quarter spanning 2018 and 2031. The economy is operating well below capacity. We need to be targeting a consistent rate of growth between 2.0-2.5% to maintain market share and competitiveness and to engender a feeling of national progress. Through a long-running series of monetary and fiscal missteps, the UK has managed to engineer a doom loop of domestic stagnation. The OBR again: ‘After falling slightly in the near term, per person real household disposable income in 2030-31 is over ¾ per cent below our March forecast and only 2 per cent above its pre-pandemic level (my italics. Ed.).’

The Budget’s glim highlights….

There are modest annual savings through energy bills and a new £100/household “house energy payment” for 22m homes this winter; the latter is a big political reversal: exactly two years ago Rachel Reeves botched the abolition of the Winter Fuel Allowance. However, they lose their impact when, since the beginning of the Iranian conflict, the cost of filling the average family car has increased by over £30 every time you visit a garage. Amending import tariffs to save a few pennies on the price of a garlic bulb or a bottle of gherkins (gherkins! Why gherkins?) grabs the headlines but little else.

There was undoubted relief that the Chancellor left CGT alone and did not attempt introducing new wealth taxes as had been feared. That said he could not resist kicking landlords and savers again with another 2p of income tax on top of the higher rate yet to come into effect from Reeves’s time in office. If landlords are pariahs, the banks are targets of populist hate too: still made to wear sack cloth and ashes as a badge of their never-ending shame for the Global Financial Crisis, they have been hit with a new surcharge to the existing surcharge on the base level of corporation tax.

As part of Burnham’s devolution programme, regional mayors and councils will keep all the money they raise in business rates, joined also by a share of national income taxes; where are the terms and conditions? To whom are councillors accountable for this transfer of fiscal responsibility? Healey had already trailed a flagship announcement of £20 billion investment for smaller dual-use defence companies, energy businesses and AI developments; this will be channelled through two quangos, the National Wealth Fund and the British Business Bank, over 5 years with a view to creating over 100,000 jobs by 2035. An eye catching policy, and welcome in those sectors, the reality is that it only constitutes around 0.7% of today’s GDP and requires a significant multiplier to make much difference to the economy (indeed, it is already baked into those new OBR forecasts).

…and the depressing lowlights

The former defence secretary and now Chancellor has obviously been stung by the entirely justified criticism levelled against him after resigning in protest at the inadequacies of the Defence Investment Plan introduced by Keir Starmer in June. Responding in the Budget, Healey perversely now endorses that plan and pledges that the UK will meet NATO’s requirements for 3.0% of GDP on core defence by 2030, rising to 3.5% by 2035. It is obvious that he still does not know how that funding will be met. Apparently all will become clear at the March 2027 spending review. Last summer, we urged pace and energy for defence spending. Recently, National Armaments Director Rupert Pearce made the same plea. We are both falling on deaf ears. Labour’s is a leisurely linear stroll: it took a year to publish the Strategic Defence Review; it took another year and a major row culminating in the defenestration of a prime minister to deliver a Defence Investment Plan; it will have taken another nine months to work out how to pay for it. Nearly three years to get it together: in context three-quarters of the duration of WW1 simply to get the basics in place.

While Healey’s hapless successor at the MoD, Wes Streeting, is having to find £2 billion of in-year savings and training has been slashed to save money, President Zelensky was only too pleased to be the beneficiary of a new package of humanitarian and military aid totalling £10 billion. As Healey reported to the Commons, Zelensky was grateful: ‘you’ve made my day’. Not many in the British armed forces will be sharing the sentiment. Contrary to Mr Streeting’s crass advice to ‘prepare for war in 1,000 days’, purchasing a wind-up radio and stocking up with candles, matches, baked beans and cheap white wine (Angela Rayner’s cerebral contribution to the debate) is not a defence strategy. It’s a funk.

Welfare: self-interest and studied misinformation

When it comes to government spending, welfare is the main battleground. Already it is mired in a confusion of language bordering on misinformation and disingenuousness. Healey pledges to “cut the benefits bill by the next election but we’ll do that in a Labour way”. In the 2025/26 fiscal outturn, the government spent £151.5 billion in aggregate on non-pension benefits. The inference is that cuts will reduce outgoings below that figure. This is not so. The OBR projections say that by 2032, the equivalent sum will be £194.2 billion. It will be that latter amount that Healey will be aiming to shave. Last year, a back bench rebellion about cutting £5 billion from the projected 2029 benefits bill nearly brought down the government; Healey will face the same challenges.

One fiscal area seldom discussed is public sector pensions. This represents an unfunded £1.4 trillion liability. There is no public sector pension fund: today’s public sector pensions are paid out of today’s tax receipts topped up by employee contributions. In 2026/27 the government is expected to pay out £58.2 billion in pensions to retired public sector workers. Public sector wages are accelerating at 6.3%, much faster than inflation. Based on defined benefits, the compounding effect of such wage growth on final salary pensions is obvious. 

 Addressing welfare and government spending “In a Labour way” is political code for attempting to manage fiscal prudence while not alienating the Party’s client state: benefits claimants (whose ‘benefits’ they now regard as entitlements and rights), the public sector and the unions. They will look after their own first.

Get a grip!

I have previously described current government fiscal policy as ‘faffing about at the edges’. With a complete absence of addressing fundamental structural economic imbalances, nothing in this Budget changes that view. John Healey has merely deferred the hard choices confronting him. Government can certainly influence growth but it does not control it; this government is confusing control of the economy through intervention with controlling growth. It controls the rates of taxation and what is taxed, but it does not control the nominal tax receipts. What it does control is expenditure.

Healey should be unleashing the private sector and allowing it to flourish. With time freed up, he should be devoting 99% of his attention on controlling expenditure. Our problems could quickly be solved. As it is, he is making little difference to either. His desire for a ‘breathing space’ simply increases the inevitability of that impending fiscal crisis forecast by the OBR happening in the 2030s. It can still be avoided but only with decisive action. He needs to get a grip. Fast.

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