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Rachel Reeves puts faith in investment to kickstart UK growth

The UK economy is stuck in a low-growth rut and has been for years. Like other developed economies, the country’s average annual expansion rate has stalled since the 2008 global financial crisis, with severe consequences for living standards.
An often cited statistic among economists is that real wages in the UK are barely any higher than they were 16 years ago, the worst run for at least a century. Something, then, must be done.
Rachel Reeves is acutely aware of this problem. Ask the chancellor for her thoughts on what the magic elixir could be to cure the UK’s economic affliction and she will give you a straightforward answer: investment, investment, investment.
Her first budget on Wednesday is the most consequential since the David Cameron and George Osborne emergency statement in 2010, when they headed the new Conservative-led coalition government. It will be crucial for both kickstarting the UK’s tax and spending agenda under the first Labour government in 14 years and, politically, arresting a slide in the party’s approval ratings.
The chancellor is planning around £40 billion of fiscal tightening, the bulk of which will come from tax rises, with capital gains tax and employers’ national insurance contributions identified as key revenue raisers. This will be offset with an increase in public investment spending, possibly on things like railways, bridges and green energy projects.
Collectively, the measures could make this budget the largest in cash terms in the past three decades.
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A potential £20 billion rise in government investment will be financed by an accounting trick that will force the Office for Budget Responsibility (OBR), the spending watchdog, to examine a wider net of government assets and liabilities when forecasting the trajectory of the public finances.
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This tweak to the fiscal rules — to include, most likely, public sector net financial liabilities (PSNFL) rather than public sector net debt excluding debt held by the Bank of England (PSND ex BoE) — should give the chancellor the headroom to borrow as much as £50 billion more.
A greater scope of public financial assets are accounted for under PSNFL, the largest being the student loan book and government equity stakes in companies, which pushes down the debt-to-GDP ratio more quickly compared to PSND ex BoE.
How much of that windfall she spends on investment, and the perceived quality of that spending, will determine whether Reeves can keep the bond markets on side. She will have to convince them, and the OBR, that the move can boost growth.
Chronically low investment has held back the economy, with the UK lagging behind similarly rich nations for years. Since 2000, the country has ranked third bottom out of 38 countries in the Organisation for Economic Co-operation and Development (OECD) for public investment.
Sluggish investment is partly the result of successive Conservatives chancellors cutting capital spending to meet their fiscal rules over the past 14 years. Abolishing a project that has not even started is a much easier political sell than raising income taxes.
Under plans set in motion by Jeremy Hunt in this year’s March budget, government investment would have fallen from around 2.5 per cent GDP this year to 1.5 per cent by 2029/30, about £20 billion a year in cash terms, the same value as Hunt’s four percentage point decrease in national insurance contributions.
James Smith, research director at the Resolution Foundation, said: “The government should take the lead by getting the UK off the bottom of the OECD league when it comes to public investment. In this way it can boost growth directly but also crowd in more private-sector investment ”
Lord (Jim) O’Neill of Gatley, a former Treasury adviser and chief economist at Goldman Sachs, said: “Borrowing to invest can not only be good, but it is essential for this government with its growth ambitions. Given the UK’s multi-decade problem of weak investment spending, it is crucial that the most patient investor of them all, the government, demonstrates serious ambition.”
A recent paper published by the OBR pretty much gave the green light for governments to fire up public investment. It argued that a sustained 1 per cent of GDP increase in public investment could raise the economy’s maximum potential output by 2.5 per cent after 50 years.
The International Monetary Fund has been similarly optimistic about greater capital spending. According to a 2015 staff study from the Washington-based organisation, increased public investment “raises output in both the short and long term, crowds in private investment, and reduces unemployment, with limited effect on the public debt ratio”.
This is no free lunch, however. Governments can waste taxpayers’ money. Borrowing can push up interest rates, resulting in private sector businesses curbing investment. Projects can be dropped or curtailed before reaching their conclusion while still incurring high costs (see HS2).
Given Labour’s huge Commons majority, it seems the only hurdle it must overcome at the budget is the bond market, a mighty force that effectively condemned Liz Truss to being the shortest-serving prime minister in history.
There were essentially two problems with Truss’s fiscal strategy that led to her demise: preventing institutions such as the OBR from examining her £45 billion of unfunded tax cuts and demonstrating this clear disregard during a huge global bond market sell-off. The IMF did not help her by effectively calling for the entire mini-budget to be reversed, nor did regulators by failing to identify risks from pension funds pursuing liability driven investment (LDI) strategies, which exacerbated the sell-off.
Going to bond traders to fund investment, rather than tax cuts, is an entirely different story. “Bond markets are capable of distinguishing between different kinds of borrowing,” Tom Railton, director of Invest in Britain, a campaign group, said.
There are clear risks associated with a large uptick in borrowing. The gilt remit, or the amount of money the government has to raise by issuing and redeeming debt, could top £300 billion, according to Deutsche Bank. The Bank of England is ridding itself of bonds purchased during quantitative easing at an annual pace of £100 billion. Governments around the world are borrowing at a rapid clip, so investors have a wide selection of sovereign debt to buy.
Mohamed El-Erian, president of Queens’ College at the University of Cambridge and former Pimco chief executive, said: “Markets understand that productivity-enhancing investments support longer-term growth, improve creditworthiness and strengthen debt sustainability.” He stressed that “the government needs to communicate in a timely and comprehensive manner that shows how the budgetary measures enhance its ‘growth mission’”.
The creation of the Office for Value for Money by the government is an early attempt to enshrine its credibility with investors.
Dominic Caddick, an economist at the New Economics Foundation, said that government bond yields were more sensitive to investors’ expectations of how the Bank of England will respond to fiscal policy rather than fiscal policy itself.
He said that if Reeves’s announcements on borrowing are less ambitious than markets expect “then interest rates could even go down”.
Perhaps the worst kept pre-budget secret in recent times has been Reeves’s intention to revamp the fiscal rules.
The current set-up has been easily gamed by governments: chancellors can schedule unrealistic spending cuts to get debt as a share of GDP falling between the fourth and fifth years of the OBR’s forecast. This was a trick played by Hunt at the last budget, which Richard Hughes, the OBR’s chair, described as a work of fiscal “fiction”.
Swapping from PSND ex BoE to PSNFL would immediately unlock tens of billions of pounds for the chancellor by minimising the impact of the Bank of England’s bond sales on the public finances and accounting for more financial assets as well liabilities on the government’s balance sheet.
Such a tweak would result in the so-called “golden rule”, effectively financing day-to-day government spending with tax revenues, becoming the binding constraint.
Ben Zaranko, a senior research economist at the Institute for Fiscal Studies, said: “The danger is, once you start focusing too much on a single measure it ceases to be a useful measure … It creates incentives to try and get around it.”
Zaranko argued that the rules should take into account a “broader set of indicators”. Others have suggested allowing the OBR to ultimately judge whether fiscal policy is credible.
Ben Caswell, senior economist at the National Institute of Economic and Social Research, said that stripping out investment spending from the targets altogether would give the government “greater scope to invest in projects that drive long-run growth”.
However, a recent report from the House of Lords economic affairs committee, titled National debt: it’s time for tough decisions, cautioned against this, as the definition of what qualifies as government capital spending was not “clear cut”.
Many chancellors over the past decade or so have tried to stimulate growth; mostly, leaving aside a brief increase in capital spending under Boris Johnson’s administration, through cutting taxes. Investment, however, has constantly remained low over this period, suggesting that Reeves may have hit upon a missing ingredient to propel the economy.
Smith, of the Resolution Foundation, summed up the need for greater investment succinctly: “There is no route to faster sustained growth that doesn’t include investing more. The country needs to stop living off its past and invest in its future.”

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