‘Why Rachel Reeves could tweak fiscal rules without spooking the markets’

US political strategist James Carville once quipped that, after death, rather than being reincarnated as the President, he would rather come back as something more powerful: the bond market. 

As scary as it might sound, the bond market is just investors from around the world buying and selling government debt. In doing this, they set the price at which governments can borrow. The higher investors consider the risk that a government will not be able to repay its IOUs, the higher the price they will ask to lend it money.

Liz Truss found this out the hard way in 2022 when her ‘mini-Budget‘, which proposed £45bn of unfunded tax cuts, caused market chaos and the cost of borrowing shot up.

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She may blame those socialist City traders, who meet up with other members of the deep state at their North London dinner parties, for the mess that followed. However, the truth is that the free market, that she claims to be so in favour of, took a less favourable view of her ability to pay back the debts she was racking up. 

Economic credibility was crucial to Labour’s election victory

The more money the Treasury spends on paying to borrow, the less is available for schools, hospitals and the police. This is why a government’s credibility on balancing the books matters. 

Rachel Reeves has worked hard to win back the public’s trust on how a Labour government would manage public finances. We would not have won the last election without being considered more competent than the Conservatives when it comes to managing the economy.

A key part of this has been the “non-negotiable” pledge to stick to the fiscal rules. These are that:

• The current budget moves into balance, so that day-to-day costs are met by revenues; and
• Debt must be falling as a share of the economy by the fifth year of the forecast.

The first of these is a commitment to reducing day-to-day spending compared to revenue, while the second considers debt as a proportion of economic output. 

Credibility in this area is about more than just fiscal rules

After the true state of the public finances was revealed once Labour got into the Treasury, there has been much debate in recent weeks about the merits of making changes to these rules. You have probably seen articles from academics, journalists or think tanks recommending changes, and the relatively relaxed attitudes that investors would take to this.

Some proposals sound eminently sensible, and the Chancellor may choose to make some of these at the Budget in October. The Tories would inevitably claim that this shows Labour can’t be trusted, while economists would note that you can’t get growth without investment.

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But this debate misses the point. The rules themselves are not what determines fiscal credibility, but the reputation of the government setting them. 

Fiscal credibility is about more than just the fiscal rules, even though they show an important intention. Manipulating figures to meet arbitrary targets would reduce confidence in the targets, not boost confidence in the government. Similarly, if investors think that they are more likely to get their money back if Britain were to meet these rules over a longer horizon, then gilt yields will reflect this. 

Keeping credibility while in power will take hard work

The Tories had fiscal rules for 14 years in government. They still lost the trust of investors and voters because they were more interested in campaigning than governing, made poor spending choices and wasted money on ideological gimmicks.

In government, Labour has been quick to show that credibility on public spending was more than just an election soundbite. The Budget responsibility bill in the King’s Speech and restrictions on winter fuel allowance to control in-year spending show a commitment to make tough choices and subject spending to appropriate scrutiny.

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Winning back credibility was hard, and keeping it in government will be even harder. The difficult job of managing departmental budgets as demand rises. The constant reviews to root out waste. Agonising choices of where to allocate scarce resources.

But this hard work will have a bigger impact on how investors rate the government’s ability to pay its debts than the precise wording of the fiscal rules. Luckily, it will have a bigger impact on the quality of the government that we run too. 

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