by Mike Denham, former chairman
Rachel Reeves is by no means the first Labour Chancellor who’s walked us to the fiscal cliff edge. Fifty years ago in the mid-1970s Chancellor Denis Healey did the same thing, eventually being forced to go cap in hand to the IMF for a humiliating bailout loan. It was a catastrophe, or as the Wall Street Journal put it at the time, good-bye Great Britain.
It’s clear to everyone that the fiscal outlook has deteriorated sharply since Reeves’ Spring Statement. Independent forecasters reckon that to meet her fiscal rules she now needs to save up to an extra £50 billion annually, either in spending cuts, or yet more tax increases, or both.
On top of that, the OBR has stepped up its warnings of fiscal crisis, with a new assessment of fiscal risks published in July. It notes that the UK now has the third highest government borrowing and fourth highest debt among the 28 advanced European economies. Our borrowing costs have already increased to be the third highest of any advanced economy in the world. We’re very close to the cliff edge, and global bond investors are poised to strike if Reeves’ second budget fails to get a grip.
Of course, the past is another country and they do many things differently there. But the brutal realities of fiscal arithmetic and market confidence are timeless.
The fiscal situation in 1975 was eerily similar to today. Healey had been Chancellor for a year. His economic and fiscal inheritance from the preceding Heath government had been a poor one, but instead of gripping the problems, just like Reeves he’d made things worse.
In his first year his main budget had been followed by two mini-budgets, the sum of which had been classic tax and spend.
He’d spent far too much, including on some huge public sector pay awards (sound familiar?), and a range of economy distorting industrial and price subsidies.
Both income tax and corporation tax had been hiked, and having come in on a promise to squeeze the rich “until the pips squeak”, he’d whacked up the top rate of income tax to a penal 83 per cent, with a ludicrous 98 per cent on investment income. He also announced he was reviewing the options for a wealth tax. Needless to say, the brain drain was in full swing, and high earners like Mick Jagger and David Bowie were fleeing the country.
His various tax increases would today raise over £50 billion annually, but even they hadn’t been enough to balance the books: government borrowing had hit six per cent of GDP, heading upwards. At the same time, long maturity gilt yields – the cost of government borrowing – had gone above 17 per cent. Monetary discipline had broken down and annual inflation was close to 25 per cent. The economy itself had contracted, and the whole dire position was summed up in a newly coined term – stagflation.
At this point, Reeves would probably argue her situation isn’t nearly that bad. And it’s true that inflation is a lot lower, albeit almost twice the official two per cent target. Also, according to the official forecasts at least, the economy is still just about growing.
But her fiscal position is in key respects worse than Healey’s. For one thing, government debt relative to GDP is now twice what it was in Healey’s day, increasing the volume of refinancing, in the main at significantly higher rates than the maturing debt. To keep those refinancing costs down, it’s even more vital to maintain investor confidence.
Also, although today’s nominal gilt yields are a lot lower, in real terms, relative to inflation, they’re now positive rather than negative. In other words, inflation is no longer reducing the real burden of debt servicing. And that effect is compounded by the fact that around a quarter of government debt is now index-linked, which was not the case in 1975.
So if Reeves is going to get a grip and head off the fiscal and economic crisis that many now fear, what can she learn from Healey?
First, if you’re walking towards the cliff edge, you should change course. Which, at the end of his first year is precisely what Healey did. In a U-turn from the previous year, his 1975 budget cut Labour’s annual spending plans by around two per cent – equivalent to over £20 billion today. It went down badly with the Labour left, but he’d grasped the nettle that desperately needed grasping.
He also raised income tax again, although this time not for the top band. He’d recognised a critical point about taxation: to raise serious money, taxes must be levied on middle income groups, whereas super-taxes on the super-rich often raise little revenue and can be counterproductive (which is why he eventually abandoned plans for a wealth tax). His two pence increase for everyone else would today raise another £20 billion, most of it from basic rate taxpayers.
So if Reeves followed Healy’s 1975 template, she’d reduce annual borrowing by around £40 billion, half from spending cuts, and half from an across-the-board tax increase on middle income groups. And that would more or less get her fiscal rules back on track.
However, as Healey’s subsequent experience showed, a better plan would be to focus entirely on spending cuts. And that’s because when it comes to market confidence, spending cuts are far more powerful than tax rises. Cuts demonstrate to nervous investors that a government is genuinely committed to living within the country’s means, and is prepared to take political pain in order to do so.
Healey’s crisis struck in 1976. After several months of relative calm, international investor confidence suddenly evaporated, and the pound plummeted by 20 per cent in just a few months. He was forced to beg for support from the US and other friendly governments (as usual the French refused to help), and then finally the IMF.
The IMF loan was for $3.9 billion, which in today’s terms would be equivalent to about £50 billion. And tellingly, its key condition was that the government undertake yet further big spending cuts. In the IMF’s judgement. Healey’s cuts thus far were not enough.
Which is how, in 1977-78, a Labour government came to deliver the biggest outright year-on-year spending cut in post-War history – four per cent in real terms, the equivalent of over £50 billion today.
The IMF loan restored market confidence, and to the astonishment of many, the accompanying cuts did not floor the economy: the economy grew in 1977, 1978, and 1979. Even more astonishing was that within months of the IMF loan the public finances had recovered enough for Healey to start reversing some of his earlier tax increases. True, Labour later lost the 1979 election, but that was largely down to the destructive abuse of union power and the Winter of Discontent.
To summarise, Healey’s key lessons for Reeves are:
- When you’re close to the fiscal cliff edge, market confidence could give way at any time.
- If your path is heading straight for the edge, change course.
- Spending cuts have a more powerful effect on market confidence than tax rises, and they don’t undermine growth as many suggest.
Healey later put down his early mistakes as Chancellor to inexperience. But he proved a fast learner, U-turning on public spending excesses within a year. If he’d moved further and faster on that, the debacle of the IMF loan might have been avoided altogether, but at least he moved. It remains to be seen whether Reeves is similarly capable of learning from her mistakes. We must confess our hopes are not high.