Rachel Reeves: Challenges and Opportunities for Britain's Economy

Rachel Reeves, the current Chancellor of the Exchequer of the United Kingdom, faces the challenge of what she calls the worst economic legacy since World War II. Leading economists concur with this view, given the high taxes, debt, and urgent need for additional public spending. "You have really high taxes, really high debt, and yet a big need to increase spending," explained Stephen Millard, Deputy Director of the National Institute of Economic and Social Research. This underscores the difficult financial situation the government has inherited. On Monday, the Labour Party plans to release the results of a public spending review, which is expected to reveal an unexpected deficit of nearly £20 billion between annual spending and revenue. This announcement is likely to pave the way for drastic tax increases to reduce the share of public debt to GDP while simultaneously investing in the repair of public services. Rachel Reeves had emphasized as early as July that this investigation was necessary because Labour had inherited a "worst set of circumstances since World War II" from the Conservatives. The Conservatives, however, argue that the current situation is less severe than in 2010, when David Cameron took over from Gordon Brown following the global financial crisis. Despite this bleak assessment, various important economic indicators show that Reeves' legacy is not entirely negative. For example, the current unemployment rate is 4.4 percent, about half as high as in 2010 and lower than when Margaret Thatcher took office in 1979 or Tony Blair in 1997. Additionally, inflation, which was over 11 percent in 2022, has fallen to the target of 2 percent, leading many economists to predict an interest rate cut by the Bank of England as early as next week. However, there are also alarming developments. GDP growth remains stubbornly weak and is below the levels that improved public finances following Blair's inauguration in 1997. GDP per capita in the first quarter remains below the level it reached before the pandemic, and the low productivity gains are hampering economic potential. A combination of lower growth and higher financing costs will make it difficult for Reeves to get government debt under control. Benjamin Nabarro, UK Economist at Citi, emphasizes that the "structural situation" today is worse than in 2010, despite the higher deficit at the time. Refinancing costs were significantly lower in 2010, as the BoE lowered interest rates to near zero and bought government bonds on a large scale. An analysis by the Institute for Fiscal Studies highlights the unusual combination of low growth rates and high interest payments as a particular challenge. The IMF estimates that to stabilize public debt, a significant increase in the difference between government spending and revenue is required. It is necessary for real GDP growth to sharply increase to 2.6 to 2.7 percent per year from 2024-25 to stabilize public finances without severe austerity measures. With the tax burden as a share of GDP already at a post-war high, there is limited room for significant tax increases. Primary surpluses will be necessary to keep debt stable, as Nabarro notes. After a decade of intermittent austerity measures and low income growth, the room for maneuver with both taxes and spending is "increasingly limited.