Has Labour learnt the lessons of the Truss mini-budget?

First, let us get the politics out of the way. It is widely expected that the Labour Party will face a punishing set of local election results next May. It is being heavily speculated in Westminster that these results will trigger a challenge to the leadership of Sir Keir Starmer. The sharp rise in support the Green Party has added to the sense of unease amongst the Parliamentary Labour Party. It is not for economists to speculate on the process that arrives at a change of political leadership for a Labour Party, but rather how the economy and financial markets might respond if it does.

Several of the more naïve figures on the left of UK politics may wish the UK government was not “in hock” to financial markets - as Mayor of Manchester, Andy Burnham, opined earlier in the year. I have wishes too. I wish that the England men’s cricket team score 500 runs every time they go out to bat. Alas, wishes and reality rarely coalesce. For an economy that borrows £2.8 trillion from financial markets, has a free-floating currency, alongside a large and persistent trade deficit - a credible economic strategy is key to avoid triggering a sharp rise in interest rates, higher inflation, and a fall in the value of the Pound.

The left wing of the Labour Party feel that the first eighteen months of this government has not been radical enough. In their eyes more public spending is needed to deliver a true Labour vision of investment in public services. This would have all the hallmarks of the 2022 Mini Budget when a frustrated caucus of Conservative members ushered in a mid-Parliament change of leadership to deliver an economic agenda more in keeping with an ideological wing of the Party - than the manifesto presented to the nation. Larger deficits in return for little upswing in growth was the verdict from financial markets.

It is worth remembering that the Mini Budget coincided with a sudden three percentage point rise in government borrowing costs, and a decline in the value of the Pound to levels last seen in 1985. Would a left-wing takeover of the Labour leadership trigger a similar market reaction? The echoes and rhythms of recent history suggest it would.

Inevitably there will be siren voices who will note the differences - as much as the similarities - four years on. There looks unlikely to be a punishingly expensive energy bailout package looming, a pivot towards the Bank of England selling government debt, nor the widely unanticipated shock of Liability Driven Investment (LDI) to amplify the market fallout. Furthermore it would appear unlikely that any left-wing pivot would be accompanied by the institutional scorched earth policy wrought by former Prime Minister, Liz Truss and her Chancellor, Kwasi Kwarteng, as they sacked the Treasury Permanent Secretary, briefed against the Bank of England, and sidelined the Office for Budget Responsibility. Having said that it is notable how the left of the Labour Party regularly take aim at these institutions. Markets take note of such grumblings.

But before the differences from 2022 emboldens the left it should be noted that there are also reasons for a far more punishing economic verdict to be meted out. Taking public spending higher than its current 44% of the entire economy at a time when such spending is at its highest sustained level since 1974 risks further crowding out the private sector. Raising taxes above levels that are already eighty-year highs risks accelerating the flight of young people, and investment. Introducing more inflationary policies when most of the rest of the developed world has inflation largely under control risks the UK looking like an international outlier.

Counterarguments will come, as they did from Truss’s outriders, that true supply side reform will accompany the traditional tax and spend levers. From the right it was long-overdue reforms to energy markets, planning, and the cost of childcare. From the left is would be greater focus on publicly funded infrastructure as an enabler of economic growth. The problem with both these arguments is the credibility gap. In 2022 the Mini Budget looked like doing the easy, popular tax cuts first – with markets doubting the political support for difficult supply-side reforms. In 2026 it would be seen as engineering the space for higher capital spending that leaks into current expenditure. In both cases the lack of a party-binding manifesto commitment on the more contentious reforms cause markets to conclude they will never happen.

Forward-looking UK investors are already playing these 2026 scenarios out in their mind and are cautious about what is to come. This is a real shame as several of the reforms made by Starmer and his Chancellor, Rachel Reeves, should start to bear fruit next year. There was also a chance that with higher fiscal headroom and the probability of a couple more UK interest rate cuts that consumers could experience a return of animal spirits to support a pick-up in growth. Whether that more favourable set-up survives the Spring is now at the gift of the left-wing of the Labour Party. Whether they have learnt the lessons of 2022 will be a substantial influence on the UK economy in 2026.