Tim Young on why UK is on edge of a fiscal crisis

In my experience, there is something peculiarly blinkered about left-wingers in the UK that leads them to reject financial advice, even when it is well-intentioned. Many on the left – and I include not only members of the country’s governing Labour party, but also the opposition Green Party – disdain financial market professionals as greedy, panicky and immoral. This primes them to suspect that warnings about the consequences of their economic policies are self-serving and aimed at undermining class enemies. Perversely, the cleverer the advice appears to be, the more suspicious they will be about the adviser, whose counsel is therefore more likely to be discounted.

This criticism should not be taken as an endorsement of right-of-centre politicians, who may be more savvy about the financial markets but tend to be far more cynical in the way they use their knowledge. It is no exaggeration to say that the UK really is dallying on the edge of a fiscal crisis, not least due to the previous Tory government’s strategy of ‘austerity’ through reduced spending, with anything spare given away in tax cuts. The edge is typically defined as something like the debt-service outlay representing 10% of government receipts, or 5% of GDP. Going over the edge would involve a sharp depreciation in sterling, and rapid rises in both inflation and gilt yields, as the UK’s debt became more ‘speculative’.

To maintain the illusion that they could run passable public services while keeping taxes low, the Tories from 2010–24 practically maxed out the UK’s national debt while running down the public sector by choosing not to invest in it. This has resulted in an expenditure backlog that is effectively a public sector liability, though it is not clearly stated as such in official statistical reports. This underlines the importance of governments adopting more of an ‘asset liability management’ approach to the public sector balance sheet. In this way, the prominence of a reported fall in the value of the public sector might have raised more alarm about the damage being done by Tory austerity.

The black hole in the public finances that Labour inherited from the Tories was in the order of hundreds of billions of pounds. This was somewhat larger than the tens of billions that Keir Starmer’s Labour government claimed to have inherited after they won the 2024 election – perhaps because they did not fully understand the true nature or size of the problem, or possibly because they feared that such a large figure would depress economic sentiment or be dismissed as wildly implausible.

That inheritance now falls to Andy Burnham. Last September, when he was still the mayor of Greater Manchester and did not even have a seat in parliament, Burnham spoke of how Starmer’s government should not be “in hock to” to the bond markets – an ill-judged remark that set him off on the wrong foot with those markets. The fixed-interest and foreign exchange markets will be on the lookout for any sign that the UK’s new government might be drifting further to the left.

Since Burnham took over from Starmer in July, figures from within his government have also given less-than-subtle hints that they are prepared to effectively game the UK’s fiscal rules by channelling investment through public financial institutions (PuFins) or via earmarked sovereign bonds.

One way in which the new prime minister might tackle the country’s fiscal difficulties would be to increase taxation – ideally via reforms that could include ideas he has supported, such as a land value tax – and spend the proceeds on restoring the public sector. That would reduce the public sector’s running costs or enable it to provide more support for private sector economic activity.

The fixed-interest and foreign exchange markets will be on the lookout for any sign that the UK’s new government might be drifting further to the left.

Tim Young

Public sector pay increases arguably represent a kind of investment in and of themselves, to the extent that they enable staff shortages to be reduced. Increased staffing allows fuller use to be made of the existing public sector capital stock, such as hospital operating theatres that have been left idle because of a lack of intensive care nurses. Provided that any increased spending on public sector pay is matched by increased taxation, the impact should not be inflationary. Indeed, to the extent that an enterprise is fully staffed, it should be more productive and could even be disinflationary.

I do not expect Burnham, or any of our career politicians, to embrace any plan quite so radical. However, they might try to apply certain aspects of it, if only as tokens of intent.

Implications for the BoE

The UK’s new government should do nothing to undermine the Bank of England’s credibility with regard to setting monetary policy, which underpins gilt prices. It should certainly not be questioning the bank’s independence.

When it comes to choosing Andrew Bailey’s eventual successor as the BoE governor, the government would also be sensible to pick someone who is considered relatively hawkish. If things went badly for the government and Labour appeared doomed ahead of the next general election, a hawkish BoE would at least leave a ‘landmine’ – albeit a benign one as far as the public were concerned – for any potentially spendthrift successors.

To ensure a greater diversity of views, I would like to see Labour appoint to the monetary policy committee a practical scientist and an experienced commercial banker. The former could take a more scientific, problem-solving approach, while the latter would bring more detailed knowledge of monetary and banking mechanics.

One final thought: I fear the temptation to shake down commercial banks by tiering reserves remuneration might be too much for a more left-leaning Labour government to resist.

Tim Young was an economist who worked as portfolio manager and subsequently trading manager in the Bank of England’s foreign exchange division, before becoming a lecturer in finance and monetary economics at the University of York. A frequent contributor to Central Banking, he died earlier this month after a long illness.