Shortly after taking office, the United Kingdom’s new Labour government announced the discovery of a massive shortfall in public finances. While much of the political debate has centered on the size of this fiscal hole, the real culprit is the set of arbitrary rules that British governments have imposed on themselves since 1997.
LONDON – Shortly after taking office, the United Kingdom’s new Labour government announced the discovery of a £22 billion ($29 billion) “black hole” in public finances, allegedly left by its Conservative predecessors. Prime Minister Keir Starmer, who had pledged to revive growth after years of economic stagnation, rising public debt, and a record-high tax burden, said he had “no choice” but to implement “painful” measures, including potential tax increases, owing to the Tories’ previous policies.
Since then, much of the political debate has focused on the size of the UK’s fiscal hole. Is it really £22 billion, or is it larger? How much of it was inherited debt, and how much was the result of the new government’s pay increases for public-sector workers? As some critics have noted, new governments tend to blame their predecessors for problems they themselves created. What is generally overlooked is that this “black hole” is a product of arbitrary fiscal rules. For example, spending kept “off budget” and “on budget” varies from country to country.
The current fiscal rules were introduced in 1997 by then-Chancellor of the Exchequer Gordon Brown to reassure bond markets that the Labour government would not engage in reckless spending. In 2010, then-Prime Minister David Cameron’s Conservative government bolstered this framework by establishing the independent Office for Budgetary Responsibility, tasked with ensuring the government adhered to its own rules.
Starmer’s chancellor, Rachel Reeves, has pledged to “balance the books” and reduce public debt as a share of GDP by the end of Labour’s five-year term. To do this, she will rely on economic growth. But reducing public spending will hamper the growth needed to achieve her fiscal goals.
The current fiscal framework is partly a reaction to the discretionary budget practices of the 1950s and the 1960s. During that period, governments prioritized maintaining non-inflationary full employment over balancing the budget. Deficits were used to reduce unemployment, while surpluses were seen as tools to control inflation. The main flaw of this approach was that stimulating growth through higher spending and tax cuts proved far easier than reducing inflation through spending cuts and higher taxes. Consequently, inflationary pressure was built into the full-employment commitment.
In response, British governments shifted their focus to ensuring price stability, making it their primary macroeconomic objective. John Maynard Keynes’s insight that even an efficient market economy cannot sustain full employment was largely dismissed. As the pendulum swung from one extreme to the other, finding a middle ground became increasingly difficult.
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Nowadays, the case for increased public investment is made exclusively in supply-side terms. Economist Mariana Mazzucato, for example, has called for mission-led public investments to achieve net-zero emissions. While clean energy offers much higher returns than fossil fuels, the thinking goes, markets alone cannot deliver the necessary investments to combat climate change, making “smart” public spending critical. As a recent Evening Standard editorial put it, a “truly radical new government” would “break with convention” and invest in “infrastructure projects that help lay the foundations of a vibrant economy.”
This argument raises two fundamental questions: Why should public investment be more growth-friendly than private investment? And why shouldn’t the private sector supply the necessary financing for green energy?
One possible answer, grounded in Keynesian economics, is that public investment, rather than crowding out private capital, would crowd in money currently tied up in speculative ventures, channeling it into the real economy. But while this is a valid argument, it makes little political headway against the notion that public spending isinherentlyless efficient than private investment.
The UK’s fiscal straitjacket cannot be loosened without demand-side measures. Although arguing for increased public investment may seem counterintuitive with unemployment near 4%, its lowest level since the 1970s, the headline unemployment rate fails to capture the economy’s actual capacity utilization. The inactivity rate – the proportion of people aged 16-64 who are neither working nor seeking employment – stands at 21.8%. With roughly 25% of the workforce employed part-time – and many unable to find full-time positions – and 6% of the working-age population on disability benefits, the true level of underutilized potential could be two or even three times higher than official unemployment figures suggest.
Last year, I argued that US President Joe Biden’s Inflation Reduction Act (IRA) contained the germ of an important fiscal concept: the balanced budget multiplier. According to this principle, an increase in government spending accompanied by an equal increase in taxation will boost aggregate demand, as some of the money taken by the tax would have been saved rather than spent.
The IRA, which includes $369 billion in clean-energy subsidies and tax breaks, also aims to balance the budget over ten years by generating an extra $739 billion in revenues from higher economic growth and corporate taxes. So far, the results seem to support this strategy: since 2021, the US economy has grown steadily, with unemployment dropping to a 50-year low of 3.4% in 2023 (before rising to 4.2% in 2024) and inflation falling to 2.5%. In the UK, Reeves considered a similar approach, but with major tax increases off the table, she faces the same fiscal constraints as her Tory predecessor, Jeremy Hunt.
Two conclusions can be drawn from this. The first is a straightforward Keynesian insight: to reduce national debt, government policies must focus on ensuring that GDP grows faster than the debt, not on cutting spending. A key lesson from 14 years of Conservative rule is that when fiscal austerity brings the economy to a halt, public debt as a share of GDP invariably increases.
Second, British governments lack their American counterparts’ freedom to disregard financial sentiment, however misguided, and cannot raise taxes at will. The exchange controls that once prevented capital flight are long gone, and the UK no longer has the imperial power to force money to stay ashore.
That said, with adequate preparation, a British government should be able to issue “net-zero bonds,” similar to the war bonds used to fund World War I and World War II, to finance its clean-energy transition. This fiscal initiative could meet both supply-side needs and demand-side imperatives.
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LONDON – Shortly after taking office, the United Kingdom’s new Labour government announced the discovery of a £22 billion ($29 billion) “black hole” in public finances, allegedly left by its Conservative predecessors. Prime Minister Keir Starmer, who had pledged to revive growth after years of economic stagnation, rising public debt, and a record-high tax burden, said he had “no choice” but to implement “painful” measures, including potential tax increases, owing to the Tories’ previous policies.
Since then, much of the political debate has focused on the size of the UK’s fiscal hole. Is it really £22 billion, or is it larger? How much of it was inherited debt, and how much was the result of the new government’s pay increases for public-sector workers? As some critics have noted, new governments tend to blame their predecessors for problems they themselves created. What is generally overlooked is that this “black hole” is a product of arbitrary fiscal rules. For example, spending kept “off budget” and “on budget” varies from country to country.
The current fiscal rules were introduced in 1997 by then-Chancellor of the Exchequer Gordon Brown to reassure bond markets that the Labour government would not engage in reckless spending. In 2010, then-Prime Minister David Cameron’s Conservative government bolstered this framework by establishing the independent Office for Budgetary Responsibility, tasked with ensuring the government adhered to its own rules.
Starmer’s chancellor, Rachel Reeves, has pledged to “balance the books” and reduce public debt as a share of GDP by the end of Labour’s five-year term. To do this, she will rely on economic growth. But reducing public spending will hamper the growth needed to achieve her fiscal goals.
The current fiscal framework is partly a reaction to the discretionary budget practices of the 1950s and the 1960s. During that period, governments prioritized maintaining non-inflationary full employment over balancing the budget. Deficits were used to reduce unemployment, while surpluses were seen as tools to control inflation. The main flaw of this approach was that stimulating growth through higher spending and tax cuts proved far easier than reducing inflation through spending cuts and higher taxes. Consequently, inflationary pressure was built into the full-employment commitment.
In response, British governments shifted their focus to ensuring price stability, making it their primary macroeconomic objective. John Maynard Keynes’s insight that even an efficient market economy cannot sustain full employment was largely dismissed. As the pendulum swung from one extreme to the other, finding a middle ground became increasingly difficult.
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Register Now
Nowadays, the case for increased public investment is made exclusively in supply-side terms. Economist Mariana Mazzucato, for example, has called for mission-led public investments to achieve net-zero emissions. While clean energy offers much higher returns than fossil fuels, the thinking goes, markets alone cannot deliver the necessary investments to combat climate change, making “smart” public spending critical. As a recent Evening Standard editorial put it, a “truly radical new government” would “break with convention” and invest in “infrastructure projects that help lay the foundations of a vibrant economy.”
This argument raises two fundamental questions: Why should public investment be more growth-friendly than private investment? And why shouldn’t the private sector supply the necessary financing for green energy?
One possible answer, grounded in Keynesian economics, is that public investment, rather than crowding out private capital, would crowd in money currently tied up in speculative ventures, channeling it into the real economy. But while this is a valid argument, it makes little political headway against the notion that public spending is inherently less efficient than private investment.
The UK’s fiscal straitjacket cannot be loosened without demand-side measures. Although arguing for increased public investment may seem counterintuitive with unemployment near 4%, its lowest level since the 1970s, the headline unemployment rate fails to capture the economy’s actual capacity utilization. The inactivity rate – the proportion of people aged 16-64 who are neither working nor seeking employment – stands at 21.8%. With roughly 25% of the workforce employed part-time – and many unable to find full-time positions – and 6% of the working-age population on disability benefits, the true level of underutilized potential could be two or even three times higher than official unemployment figures suggest.
Last year, I argued that US President Joe Biden’s Inflation Reduction Act (IRA) contained the germ of an important fiscal concept: the balanced budget multiplier. According to this principle, an increase in government spending accompanied by an equal increase in taxation will boost aggregate demand, as some of the money taken by the tax would have been saved rather than spent.
The IRA, which includes $369 billion in clean-energy subsidies and tax breaks, also aims to balance the budget over ten years by generating an extra $739 billion in revenues from higher economic growth and corporate taxes. So far, the results seem to support this strategy: since 2021, the US economy has grown steadily, with unemployment dropping to a 50-year low of 3.4% in 2023 (before rising to 4.2% in 2024) and inflation falling to 2.5%. In the UK, Reeves considered a similar approach, but with major tax increases off the table, she faces the same fiscal constraints as her Tory predecessor, Jeremy Hunt.
Two conclusions can be drawn from this. The first is a straightforward Keynesian insight: to reduce national debt, government policies must focus on ensuring that GDP grows faster than the debt, not on cutting spending. A key lesson from 14 years of Conservative rule is that when fiscal austerity brings the economy to a halt, public debt as a share of GDP invariably increases.
Second, British governments lack their American counterparts’ freedom to disregard financial sentiment, however misguided, and cannot raise taxes at will. The exchange controls that once prevented capital flight are long gone, and the UK no longer has the imperial power to force money to stay ashore.
That said, with adequate preparation, a British government should be able to issue “net-zero bonds,” similar to the war bonds used to fund World War I and World War II, to finance its clean-energy transition. This fiscal initiative could meet both supply-side needs and demand-side imperatives.