Ghosts of the ‘70s haunt Labour’s economic resurrection

Rachel Reeves
With polling day less than two weeks away, Labour's spending plans are coming under scrutiny - Justin Tallis/AFP

In early September 2022, this column forecast the ‘Gnomes of Zurich’ could soon be returning to British politics.

Even before Liz Truss became Prime Minister, and more than six weeks before the now infamous ‘mini-Budget’ in late September, Economics Agenda warned that with growth anaemic and inflation in double-digits, a cash-strapped UK government – shouldering an extra £400bn of lockdown-era debt – could soon face serious borrowing difficulties.

And so it came to pass – although I’d maintain the Bank of England’s bizarrely-timed decision to start unwinding its vast quantitative easing (QE) programme just days before the short-lived Truss government unveiled its fiscal programme helped spark the subsequent bond market squall.

It wasn’t just huge Ukraine-related household energy subsidies that spooked financial markets, causing the spike in government and economy-wide borrowing costs that led to the repeated claims, not least during this election campaign, that “Liz Truss crashed the economy”.

It was also Threadneedle Street’s announcement, on the eve of the mini-Budget, that the Bank would be selling back into the market tens of billions of pounds of gilts previously bought with newly-created QE “funny money” – funds spent on furlough and countless Covid business loans.

The prospect of all that extra QE debt being sold inflamed financial markets, with gilt prices immediately falling, pushing up yields before then-chancellor Kwasi Kwarteng had delivered the “mini-Budget”. The Bank’s previous failure to match the US Federal Reserve’s decisive interest rate rises meant sterling was already under pressure.

Of course, Truss not sharing her plans with the Office for Budgetary Responsibility raised eyebrows. And much in the presentation of her higher-growth-lower-tax policies played into the hands of her ideological enemies across the policy-making establishment.

I mention all this because, with polling day less than two weeks away, Labour’s spending plans are coming under scrutiny. And the party’s claims it can significantly increase spending “without raising taxes on working people” rely heavily on Labour’s own decidedly Truss-ite “pro-growth” policies delivering the economic expansion needed to justify higher borrowing.

The position seems to be that a Labour government can borrow more with no problems whereas Liz Truss couldn’t, precisely because shadow chancellor Rachel Reeves “used to work at the Bank of England” and isn’t Liz Truss. This isn’t true – and claims that it is risk sparking bond market turmoil and resulting economic chaos far worse than we saw in the autumn of 2022.

Back in the 1970s – a time of sky-high inflation and serious financial turbulence – ‘Gnomes of Zurich’ was a term widely-used to describe the distant but powerful world of global financial markets.

Coined by Labour deputy leader George Brown, this disparaging phrase represented in the public mind the limits placed by financiers if governments borrowed and spent too much – with a tumbling currency and fiscal meltdown as investors charged ever more to lend.

This happened in 1976, an episode too often erased from Westminster’s collective memory, when Britain suffered the ignominy of having to be rescued by the International Monetary Fund. A generation of industrial subsidies, soft-budget constraints and “spend to grow” hubris backed Britain into an insolvency cul-de-sac. After months of denial, the markets forced Jim Callaghan’s Labour government, “cap in hand”, to seek an IMF bailout.

I’m not saying that will happen over the coming months. But the notion it couldn’t because Truss and the Tories will be gone is reckless in the extreme.

Some say Labour is set to “get lucky” with the economy – coming into office as the cost of living crisis is easing. Inflation hit a near three-year low last week, with the consumer price index rising just 2pc during the year to May, hitting the Bank of England’s target, and down from 2.3pc the previous month.

But with food prices still 25pc up compared to early 2022 and energy bills some 60pc higher, millions of cash-strapped households are unlikely to thank Rishi Sunak’s Tories for making them feel richer.

Pay growth was 5.9pc between February and April, compared to the same period last year – and retail sales rose 2.9pc in May, up from 1.8pc the month before.

But with service sector inflation still 5.7pc, household budgets remain stretched and the Bank’s monetary policy committee is unlikely to lower rates from their 16-year high of 5.25pc before the autumn.

Any “feelgood factor” will come far too late for Sunak. And the latest business survey data from the influential Purchasing Managers Index suggests recent green shots could anyway be crushed. The UK’s PMI service sector reading – covering four-fifths of our economy – slowed to 51.2 in June, with readings above 50 pointing to growth. That’s down from 51.9 the previous month to a seven-month low.

While the manufacturing index rose to 51.4, the “economy-wide” PMI measure dropped steeply from 53.0 to 51.7, suggesting official GDP data for June will disappoint.

As it lays out its fiscal plans this autumn, an incoming Labour government is hoping for a growth spurt before new policies are enacted or new spending announced. That may happen. But, then again, it may not.

Britain’s national debt has soared from £1.8 trillion when lockdown began in March 2020 to £2.7 trillion – with debt now at its highest as a share of GDP since the 1960s.

The Government spent £102bn servicing our massive debt pile last year, almost twice the annual defence budget. In May we borrowed another £15bn, while paying £8bn in yet more debt interest.

Several prominent hedge fund managers – today’s ‘Gnomes of Zurich’ perhaps – now suggest Labour could increase the pace of borrowing without causing “a Liz Truss-style gilts crisis”.

Relying on that gambit is about as risky as leaving a fox in charge of the hen house.