Labour leadership rivals must sell themselves to bond markets
By Simon French, Chief Economist and Head of Research
Last week the interest rate paid by the UK government to borrow for ten years rose above five per cent. The last time the interest rate was that high was eighteen years ago.
Back then, in 2008, there was £500 billion of UK public sector borrowing to finance. Today that number is just under £2,900 billion. Even allowing for inflation, this has been one of the fastest increases in public sector debt in the developed world. Successive economic crises have increased the national debt at a pace last seen when the UK was at war.
The annual cost of funding this debt pile has jumped to 3.7% of everything the UK economy now produces. That may not sound like much, but at £100 billion a year, debt interest is 50% more than the entire UK defence budget. An ageing population tapping into more pension and care provision is expected to make those debt numbers even worse over the coming decades.
For a governing Labour Party now toying with increasing defence spending - whilst also anxious to support households and businesses poised to face another energy price shock - these bond market signals should act as a stark warning. Having already pushed the UK tax take to an eighty-year high, the wriggle room to tap households and businesses for more tax, or the financial markets for more borrowing, is limited.
Whilst it is true that a UK government issuing debt in its own currency - Sterling - will always be able to sell its own debt, or create it through its own central bank. It is simultaneously true that the privilege comes at a cost. Higher inflation and higher interest rates will result. And those costs are clearly stacking up.
This week sees UK local elections that are likely to deliver a punishing verdict for the Labour Party. Financial markets are watching on closely. It goes without saying that a mid-Parliament change of Prime Minister, a decisive economic pivot, and all without a fresh electoral mandate, went down like a cup of cold sick under Liz Truss in 2022. Will Labour fare much better if they try such a strategy in 2026? I very much doubt it.
Potential alternatives for the Labour leadership, notably Andy Burnham and Angela Rayner, have spotted the danger posed by the judgment of bond markets and have begun opining about the UK’s fiscal position. Ed Miliband, perhaps stung by his infamous failure to mention the deficit in his 2014 Labour Party Conference speech, has stayed notably silent.
The principal question is whether these, and other wannabee Prime Ministers from the Labour benches, have diagnosed the UK tax and spending issues correctly?
As I noted at the start of this column, the UK public finances have deteriorated in recent years, but they are also far from the worst in the developed world. Indeed, the UK’s deficit reduction path for the remainder of the decade under the current Chancellor, Rachel Reeves, is the more austere in the G7. Furthermore, the UK’s debt position, whilst extended at almost 100% of GDP, is still the second lowest amongst the G7. If it was all about these numbers, then the UK’s outlier status in debt markets would be hard to justify.
No, what is required to lower the UK’s borrowing costs is a credible path to reduced inflation. And this is where the likes of Rayner and Miliband need to tread more carefully. In investor calls I have hosted in recent days those lending to the UK government, or considering owning UK assets, ask what to make of a potential Rayner or Miliband-led government. These are politicians whose signature policies in Cabinet have been the Employee Rights Act, the Renters Reform Act, and a costly and intermittent energy strategy.
The evidence so far is that these policies have added to the cost of UK employment, the cost of providing rental accommodation, and the cost of UK energy. A rational investor would simply conclude they should demand an even higher inflation premium on owning UK government debt under the stewardship of individuals associated with such policies. That either emerges because of expectations the Bank of England would need to keep interest rates higher for longer, or that the higher cost of employing, renting, or consuming energy in the UK economy would be signals of a wider inflationary bias.
Put bluntly, those investors with global choices on where they put their capital may not be fans of Sir Keir Starmer, or Reeves, but everything I have seen suggests they worry more about who could replace them during the current Parliament.
The question that pretenders to Number Ten Downing Street should ask themselves is: do I have a good story to tell on lowering inflation that does not involve price caps, and crushing the incentives to create growth? A story that may appeal to the center-left is lowering the regressive tax that is inflation in core staples like energy, and food. An anti-inflation story that would, by my judgement, take up to £20bn a year off the interest rate bill faced by the UK government.
Economies that have successfully lowered inflation - including the UK after 1979 - have enabled economic activity, rather than try to stage-manage it. They attempted to tread more lightly on the lives of small business owners, and incentivised capital to be put to work - not try to mandate it. They have enabled energy pluralism, not attempted to pick winners in the energy transition. They have allowed prices to be effective market signals, rather than cap them.
It may be that the local elections pass off without sustained political fallout. It may be that financial markets remain focused on events in the Straits of Hormuz, rather than the Palace of Westminster. But the bond market continues to send clear warnings that it judges the UK has become a high-inflation, high-spending economy again. It would be better to heed those warnings, than test them further.
