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Dear Mr Burnham,
Congratulations on becoming prime minister. As you get settled into No 10 Downing Street, let me remind you of Barack Obama’s encapsulation of good policy: “Don’t do stupid stuff” (though what he said was rather more pungent). A brief study of the fate of your predecessors will suggest that doing “stupid stuff” is often the source of the problem. So, to put the point simply, avoid really big mistakes.
The biggest mistake of all would be to imagine the country enjoys a free fiscal lunch. In fact, it only has hard choices. These have to be faced, not because fiscal stability is a great aim in itself, but because it is a necessary condition for achieving all the things that matter.
As the latest IMF Country Report on the UK (published last week) notes, “Since 2022, UK gilt yields — particularly at long maturities — have risen and moved above G7 peers. Elevated long-term yields increase sovereign borrowing costs and can transmit to financial conditions more broadly, with implications for fiscal sustainability and financial stability.” This is IMF-speak for “Be careful — investors do not have much confidence in your country.”
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On July 16, the yield on 10-year gilts was close to 5 per cent, against 4.6 per cent in the US, 4 per cent in Italy and 3.1 per cent in Germany. Assume that the UK hits its inflation target of 2 per cent: this implies a real interest rate of around 3 per cent, which is more than double the IMF’s forecast rate of economic growth up to 2031. If the UK government created big primary fiscal deficits (before interest), which then added to its already costly long-term debt, the dynamics would be dangerous.
Why are UK bonds costlier than those of any other G7 country? The IMF breaks the yields into two components: the expected path of short-term interest rates and the “term premium”. The former is driven by views on inflation, fiscal policy and other macroeconomic features: UK inflation is relatively high, for example. The latter is driven mainly by perceptions of relative riskiness. The IMF notes that “market feedback suggests that the September 2022 gilt market turmoil marked a structural shift in the fragility of the gilt market.” Liz Truss casts a long shadow. The IMF also notes changes in the investor base, with a reduction in holdings by pension funds and an increase in holdings by flighty hedge funds.
The bottom line is that a country with a low national savings rate and a significant structural current account deficit, which is also viewed as somewhat politically unstable, cannot afford to put its fiscal credibility at risk.
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In my view, the UK needs to be on a fiscal path that credibly lowers the trajectory of public sector net debt relative to GDP. It also needs to improve the quality of the public sector balance sheet. What makes achieving this both more important and even more difficult is the pressure for higher public spending that comes from existing commitments and the ageing of the population.
Thus, according to the Office for Budget Responsibility, between 2024-25 and 2050-51, spending will rise by 6.8 per cent of GDP, just for these reasons: 3 percentage points on health; 1.8 percentage points on defence; 1.2 percentage points on climate-related spending (which is surely now inevitable); 1 percentage point on pensions; and an offsetting 0.2 percentage point fall for education.
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You have to put forward a credible plan for managing the public finances in the medium- to long-term. The ideal way to do so would be to focus the autumn Budget on both spending and revenue. A big question here is how far you will feel bound by the decisions made under your predecessor. Ideally, you should not. Instead, you should make some painful decisions on spending and taxation. But if you are to succeed, both must be set in the framework of a wider programme of reform that would plausibly strengthen incentives for work, innovation and investment, raise national savings, improve prospects for growth and also be seen as fairer. There is no way of doing this, in my view, that does not include substantial reform of taxation and spending.
It is, no doubt, rather naive to expect a plan that builds on the foundation of stability and goes on to deliver coherent reform, particularly when this parliament has no more than three years. But the previous government has started some good things — planning reform, for example. With some things you desire added and a willingness to reform tax and spending, you could still do a great deal.
But, above all, do not forget the UK’s fiscal credibility. This, as we know too well, can be ruined in a very few days.
Yours, Martin Wolf
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