In October 2024, Chancellor Rachel Reeves presented her "budget for growth," but the Office for Budget Responsibility (OBR) cut its UK GDP forecast. This first of two blogs by Dimitri Zenghelis sets out the macroeconomic reasons why the measures, despite good intentions, are not likely to achieve the desired boost to UK investment, productivity and growth.
In October 2024 Chancellor Rachel Reeves stood at the House of Commons dispatch box and presented her “budget for growth.” The Office for Budget Responsibility (OBR) remained unconvinced. The government’s fiscal watchdog shaved 0.2% off its forecast for UK GDP in 2029, as a direct result of the October 2024 Budget measures.
In this, the first in a two-part blog, I will look at the fundamental macroeconomic reasons why the Budget measures, despite good intentions, could never have been expected to deliver Reeve’s long-awaited boost to UK growth. In the second, I will discuss what the government can do to reinstate its plan for growth.
What went wrong in early October? Not the government’s desire to boost UK investment. It has been clear for many years that the UK has underperformed in terms of productivity as a direct result of a decade of underinvestment.
The Budget delivered on the promise to boost public investment necessary to raise UK productivity. It included an overdue refocussing of the fiscal rules in favour of investment in productive assets. The commitment to steer investment into perhaps the largest growth opportunity of the twenty first century, the supply of clean, digitally-enabled and efficient energy and production was also welcome, helping enhance UK competitiveness in the long term.
However, since the pandemic the macroeconomic landscape has radically reshaped. In the flat decade following the 2008 financial crash, the economy was operating with significant spare capacity and an ample supply of zero real interest rate borrowing available from abroad. This could have been used by previous governments to build the core infrastructure the country needs. It provided significant potential to crowd-in private investment and generate multiplied increases in short run and long run production.
The primary economic concern has since shifted to controlling inflation. Prices first started to accelerate following post-covid supply constraints. This was compounded by spiking fuel and commodity prices following Russia’s invasion of Ukraine. But an unexpected lack of additional capacity in the UK economy, reflected in rising capacity utilisation rates and growing vacancies, threatened to entrench rising core price inflation.
Even though additional public investment is necessary to boost UK capacity in the long term, it has little influence on capacity today. But the spending does have an immediate impact on UK demand. This is where Reeve’s problems begin. Higher demand in an economy already close to capacity increases inflationary pressure.
It also draws in net imports from abroad to meet the increased demand which cannot be supplied domestically, the payment for which requires a corresponding increase in borrowing from abroad. The effect is to widen the UK’s current account deficit, which itself would be expected to weaken the value of the pound (as pounds are exchanged for FX to buy foreign goods) raising the cost of imports and further boosting domestic inflation.
The Bank of England has a duty to respond to this extra inflationary pressure by imposing higher-for-longer policy interest rates to choke off any additional inflation and return the rate of general price increases to target. In anticipation of higher central bank rates, UK borrowing costs rose immediately after the Budget, to their highest levels of the year with the 10-year gilt yield climbing to 4.45% by the following morning.
Overnight, the cost of private investment went up. The OBR noted that “higher government investment increases incentives for businesses to invest, but in the near term this is more than offset by the crowding out effect of the fiscal loosening in this Budget”. The OBR raised both Bank and gilt rates by a ¼ percentage point across the forecast and at all maturities, and its business investment forecast was correspondingly paired back.[1]
The bottom line is this: to bolster investment today in an economy close to capacity, without putting pressure on inflation or the external payments balance, the government needs to create immediate space by cutting consumption (as opposed to investment) expenditure to prevent excess demand. To do this, it must shift the current budget towards surplus while the economy is running close to capacity. It can either cut public consumption, which after years of pairing back public services might prove counterproductive, or it could ask that households share the costs of much needed public investment through increased general taxation, which constrains their spending power.
Otherwise, under current economic conditions, every time the government tries to push up UK investment, the markets will act to push it back down. In spring 2024, Anna Valero and I warned of precisely this effect.
In the next blog, I will assess the extent of the UK’s saving deficiency and explain why it requires urgent and targeted attention to deliver the governments growth aspirations.
[1] Higher interest rates might be expected to bear down on consumption too, but the effect will be much smaller than on investment, not least because by raising the returns to savings, some households will be encouraged to save less and consume more in expectation of receiving the same interest income.
The views and opinions expressed in this post are those of the author(s) and not necessarily those of the Bennett Institute for Public Policy.
