Rachel Reeves is considering changes in next month’s budget to the government’s so-called fiscal rules, which govern how much it can spend.
The changes are aimed at paving the way for billions of pounds more investment in the UK economy, to help decarbonise the economy and reboot growth.
Reeves signalled the change in direction in her speech to the Labour party conference on Monday, saying “it is time that the Treasury moved on from just counting the costs of investments to recognising the benefits too”.
But with government debt running at 100% of GDP, and a total debt pile of £2.5tn, there are questions over how far Reeves could go.
Would this break a manifesto pledge?
Before the general election, Reeves pledged to meet two fiscal rules, which were largely unchanged from the self-imposed measures drawn up by her predecessor, Jeremy Hunt.
The first manifesto pledge was that day-to-day spending would be balanced with tax receipts.
Speaking at a fringe event at the party’s annual conference, Reeves stressed this measure would be “incredibly hard” to meet and would still require the government to make “tough decisions” on tax and spending.
“The £22bn black hole in the public finances makes that even harder,” she said. “If you carry that £22bn forward for every year of the parliament, the previous government would not have met their fiscal rules, and we won’t meet our fiscal rules, so that’s why we have to take action at the budget in October.”
The second rule was that debt must be falling as a share of the economy by the fifth year of forecasts produced by the Office for Budget Responsibility. This is where Reeves is most likely to make changes.
While this could break a manifesto pledge, the Treasury sees things differently: Reeves could argue she is changing the definition of debt, while still committing to bring down this alternative measure.
Why does the Bank of England matter?
One well-trailed idea is excluding the losses for the Treasury on the Bank of England winding down its crisis-era quantitative easing bond-buying programme. Experts say this could open up £10bn-£20bn of headroom.
Threadneedle Street amassed bonds worth £895bn as it battled the 2008 financial crisis and Covid pandemic. However, they are now being sold for less than was paid, with the Treasury picking up the tab. Total losses could hit £100bn over the next decade.
Reeves got a £10bn boost earlier this month when the Bank announced it would sell £100bn of bonds over the next year – less than the OBR expected, and therefore crystallising fewer losses. However, excluding the losses altogether would add further headroom.
Could the chancellor argue green investment should not add to debt?
Reeves could exclude Labour’s new public investment companies from the debt targets, allowing the chancellor to borrow as much for these vehicles as she thinks the market will have appetite to lend.
Britain is an outlier compared with several countries that already do this with their state-owned energy companies.
Sources said trade unions had briefed the Treasury on this, highlighting how Germany excludes the energy company Stadtwerke München. Ørsted’s borrowing is not included in Denmark’s national figures, Vattenfall’s debt is not counted by Sweden, and neither Statkraft nor Equinor feature in Norway’s. Germany’s state-owned development bank, KfW, is also excluded.
This is because the Maastricht Treaty’s definition of debt excludes publicly owned entities engaged in “corporate activity” or “market production”, definitions which include the liabilities of savings banks, public utilities and waste management operators.
Allies of Ed Miliband say the energy secretary has argued for keeping the new institutions off the government balance sheet, but that he is not part of the pre-budget decision-making process.
Could Reeves change the debt target?
Currently the fiscal rules target public sector net debt (PSND), which measures the stock of past borrowing and totals £2.5tn. But this measure does not give any credit for huge swathes of assets that the state owns, from roads to public parks.
Reeves could decide to target an alternative already tracked by the OBR: public sector net financial liabilities (PSNFL), which take into account all financial assets and liabilities and totals about £2.4tn.
At the March budget, public sector net debt was forecast to rise, before a modest fall from 93.2% of GDP to 92.2% in the fifth year – meeting Hunt’s fiscal rule with £8.9bn to spare in cash terms.
On the alternative measure, debt was forecast to drop in every year – including a significant drop from 80.6% of GDP to 78.7% in the fifth year, worth more than £50bn in cash terms.
The main source of difference is how public assets, on which the government would expect a future financial return – including student loans and equity stakes in companies – offset liabilities, such as government debt and public sector pensions.
“The current debt target sets an incentive to sell off illiquid assets – like the student loan book – without regard for whether you get a good price for it, or whether you think the public sector, or private, are better placed to manage it in the long term,” said Isabel Stockton, an economist at the Institute for Fiscal Studies thinktank. However, there could also be challenges. “If that became your main fiscal rule, you’d be concerned about the incentive for gaming the system – to organise more parts of public spending as loans.”
Could the chancellor go further?
One of the most flattering possible measures Reeves could target is public sector net worth (PSNW), which includes non-financial assets – such as the road network, schools and hospitals – alongside financial ones.
Using these assets to offset the government’s liabilities, the measure currently shows a deficit of about £700bn – a considerably lower sum than Britain’s headline £2.5tn net debt pile.
Taking this broad view could help show the value of investing in everything from buildings and roads to machinery, intellectual property and artworks. Economists at the International Monetary Fund praised the metric in July, saying it was “more conducive to public investment and economic growth,” and could still act as an anchor that “precludes unsustainable debt dynamics”.
However, the measure could be tough to adopt, as non-financial assets can be difficult to value. Roads like the M4 motorway and buildings like No 10 Downing Street might be undesirable to ever sell, or to dispose of quickly.
Expanding the scope of what the government counts under the measure could also bring in some unhelpful liabilities, such as PFI contracts – which have been deliberately taken off the government books – and unfunded pensions schemes.
For these reasons, economists often argue PSNW should not be the main target a government adopts, but could be helpful as part of a wider set of measures because it could help to incentivise investment.
Would there be a risk of a Truss-style market reaction?
Part of the reason Reeves has stuck so neatly to self-imposed fiscal rules is for political reasons – to show voters that Labour can be trusted with the public finances. But it is also to demonstrate to financial markets that the new government is committed to avoiding a repeat of Liz Truss’s mini-budget.
The Treasury has previously warned that any increase in borrowing is likely to increase inflation and interest rates, according to one official who has recently departed the department.
The person added: “I think officials will be a lot more comfortable with the Bank of England change than an open-ended allowance for the government to borrow as much as it likes to fund capital spending. Once you have carved out GB Energy, why not make it much bigger and load it up with debt?”
Jeremy Hunt, the former chancellor, tweeted on Thursday: “My advice from HMT officials was always very clear on this: more borrowing means interest rates stay higher for longer.”
However, the current fiscal rules have become increasingly discredited among leading economists. Stockton at the IFS said that frequent changes to the rules could alarm markets, but suggested some tweaks would be welcomed.
“It certainly looks like keeping KfW outside the German debt rule doesn’t impact the costs that Germany can borrow at. Investors seem fine with that,” she said.
Andrew Goodwin, chief UK economist at the consultancy Oxford Economics, said Truss had spooked markets after undermining the Treasury and the Bank of England, and by announcing large tax cuts that would have done little to boost the long-run potential of the UK economy.
“It partly depends on the scale and type of loosening that Reeves employs after changing the rules, but I think the risk of a Truss-style event are very low,” he said.
“If Reeves were to use the extra headroom to boost investment, then I think markets would view that as a sensible choice.”
