Keir Starmer’s hold on power in the UK is looking shaky, with the resignation of Wes Streeting from his cabinet the latest blow. But the spin from the prime minister’s supporters is that a full-scale leadership battle risks “plunging the country in chaos”.
Grabbing on to first quarter GDP figures showing steady 0.6 per cent growth – and a decent performance in March as the Gulf crisis hit – chancellor of the exchequer Rachel Reeves said that Britain was on the right track.
The growth figures were, indeed, ahead of expectations. But whoever is in power in the UK faces serious constraints from the market for government borrowing, where 10-year interest rates this week reached levels last seen in the run up to the 2008 financial crisis and longer-term 30-year rates hit highs not seen since 1998.
The gap between UK 10-year bond yields at 5-5.1 per cent and Irish yields circling 3.3 per cent is around record levels.
Pressure on borrowing markets frames the leadership battle and means that both Starmer and those seeking to replace him have to walk a narrow line, claiming that faster progress can be made in delivering for voters, while at the same time realising that those who lend money to the UK need to be kept onside.
This does not mean that no change in course is needed – nor that some sell-off of UK debt would necessarily cause chaos. But the problem is that the UK needs to keep lenders on board and to be able to access funding at a manageable cost. Facing up to the inevitable trade-offs is politically treacherous, as British politics has shown over recent years.
The UK plans to raise £250 billion (€289 billion) on borrowing markets this year to fund a budget deficit of 4 per cent of gross domestic product (GDP), adding to a debt pile already close to 100 per cent of GDP.
If confidence is lost on the markets then the cost of borrowing rises yet further and room for budgetary manoeuvre within existing fiscal rules shrinks – or disappears entirely.
Source: tradingeconomics.com
There were clear signs of nervousness earlier this week, when 10-year bond – or gilt – interest rates rose over 5.1 per cent as investors were fearful about looser budget policy under a new prime minister. (Bond interest rates rise as prices fall).
And the warnings of “chaos” coming from Starmer supporters have a clear point of reference – the disastrous mini-budget introduced by the short-lived government of Liz Truss in 2022.
Plans to slash taxes to try to revive growth spooked the markets and led to a bond sell-off which upended a corner of the pensions market and a collapse in the value of sterling. This threatened wider chaos and required intervention from the Bank of England.
Former UK prime minister Liz Truss. Photograph: Hollie Adams/Bloomberg
High borrowing costs are already a significant constraint on UK public finances, with debt repayment accounting for over £100 billion last year, more than 8 per cent of total government spending – and a debt to GDP ratio of close to 100 per cent.
Irish debt servicing, in contrast, takes just over 3 per cent of total spending. The size and structure of UK public debt – around one quarter of which is at a floating interest rate linked to inflation – is a significant burden.
The UK economy has also been relatively weak for a prolonged period with the impact of Brexit lingering. And thus sterling is seen as vulnerable to declines against other currencies – and investors from overseas buying into UK government bonds, known as gilts, demand somewhat higher interest rates to compensate for this risk.
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In a recent report, Davy economist Kevin Timoney asked whether Britain could escape the “two lost decades” it has experienced since the global financial crisis (GFC) which started in 2008.
“The post-GFC recovery was progressing well until the Brexit vote in 2016,” he wrote, “and outcomes in the 2020s to date have been starkly weaker than in competitor countries”.
The UK economy has been bedevilled by weak productivity growth and worsening dynamics around its public finances. The national debt-to-GDP ratio rose from 36 per cent of GDP in 2007 to 96 per cent last year.
Timoney points out that Britain’s fiscal rules – aiming for a reduction in the debt ratio by the end of parliament. – rely on faster growth to be achieved and weaker growth has meant this is hard to achieve. In turn this has pushed up borrowing costs, leading to a kind of vicious circle.
The portrayal of Britain as some kind of economic “basket case” is misplaced and the Davy report is more upbeat for 2027 and 2028, feeling that artificial intelligence (AI) adoption and lower interest rates could help drive growth. But this is of course based on a solution emerging to the Gulf crisis and pressures coming off energy costs.
In the short term, of course, like all major economies, the uncertainties caused by the crisis loom large and could lead to a damaging surge in inflation in the months ahead if some solution is not found to reopen the Strait of Hormuz.
For now, the UK Institute of Economic Affairs said on Thursday that the decent quarter one figures were likely to be “as good as it gets”, with the economy suffering under the pressure of higher oil prices. Meanwhile leadership uncertainty will keep investors on edge.
The key issue for those lending money to the UK is what the political situation will mean for budget policy. Whether Starmer survives or there is a new prime minister, there will be pressure to spend more to address key issues of voter concern.
Against this backdrop – and with Labour faced with the huge recent success of Reform in the local elections – will it hold to its budget rules, or risk changing them to give more policy flexibility?
Groups allied to both “wings” of the party have published manifestos calling for sweeping policy changes including lower taxes – national insurance and stamp duty are targets – and spending to help “working people”.
Echoing the populist policy debates across Europe, the documents argue that too much of the benefits of growth have gone to the better off and that a rebalancing is needed, as well as radical measures to improve public services. Policy proposals from the left of the party also question the budget rules and argue for change.
Likely Labour leader contender Wes Streeting. Photograph: Brook Mitchell/Getty Images
Secretary of state for health Wes Streeting would be seen by investors as more likely to hold to existing fiscal rules than some of the other likely contenders from the left of the party. Candidates from the left , such as former deputy prime minister Angela Rayner, might raise more nerves, particularly in relation to budget rules.
Andy Burnham, the mayor of Greater Manchester, for long seem as Starmer’s biggest threat, does not have a seat in the House of Commons and thus cannot mount an immediate challenge. His economic agenda – so-called Manchesterism – is based on devolving control of key services such as the bus service and utilities to local, public control.
Having raised the hackles of investors last year by saying the UK should not be in hock” to the bond markets, he was reportedly intending to outline why this would not be the case, if he does get a chance to run in the months ahead.
The situation will take time to clarify – and this in turn carries dangers, as the government machine will be distracted until the Labour leadership is clarified. If uncertainty and speculation surround the future of economic policy, investors could be unsettled.
A risky period lies ahead, particularly if the Gulf crisis persists, in addition to political upheaval. Warnings about the risk of ” chaos” may be politically motivated, but this does not mean they are incorrect.