'Rachel Reeves has run out of options'

Britain’s chancellor Rachel Reeves is facing at least as much risk from her parliamentary colleagues as she is from gilt markets. Upon delivering the Spring Statement in March, she introduced welfare reforms to ensure the Office for Budget Responsibility (OBR) would confirm she had met her fiscal rules.

But tightening the criteria for disability benefits was a step too far for many Labour MPs, who rebelled once the welfare reforms came to a vote. The government only managed to pass the bill by gutting its substantive fiscal savings, leaving Reeves with an extra £5 billion to find. She broke down in tears, gilt markets wobbled, and a huge fiscal black hole looms.

Tax hikes cannot fill the gap without endangering growth and breaking a manifesto pledge. The fiscal and political constraints are now so great that the chancellor, a keen chess player, must recognise she is in zugzwang: there are no good moves left.

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One year on from a historic landslide, it seems almost impossible to contemplate that the government is unable to command a majority in parliament. And yet the welfare rebellion demonstrates the party is unable to accept the fiscal reality.

Debt interest payments total £100 billion a year, almost twice the amount spent on defence and not far off the education budget. This was her inheritance. Such is the debt albatross slung around the neck of the low-growth UK economy.

The chancellor’s first decisions have compounded the problem. Her attempts to boost growth, such as increasing public investment and relaxing planning regulations, only pay off in the long term, whereas the increase in the minimum wage and employers’ national insurance had an immediate effect on business hiring and confidence.

Is there a third way for Rachel Reeves?

But this is mere tinkering when the solution at its heart is a question of political philosophy. Would tax cuts and a small state boost growth, or must the government deliver tax and spend? Liz Truss famously tried part of the former and lost her job – but with government borrowing and the UK tax burden already at record highs, the latter strategy would be an even bigger gamble.

Reeves has tried to plough a third way, promising not to raise the big three taxes of income tax, national insurance and VAT while spending only to invest. The compromise has not worked. Rather than expanding growth, the chancellor has been forced into ever tighter corners.

The fiscal constraint has led to manoeuvres that have confounded even her own electorate. It’s unlikely Labour voters wanted to reduce benefits for the old, the disabled and children with special needs. This is a government with a majority but without a mandate for the actions that the chancellor decided to take.

The lack of a mandate is exactly what caused so many problems for Liz Truss: if Truss had won a general election on a platform to cut spending and taxes, the government might have been able to pursue such policies with impunity, à la Donald Trump.

Instead, UK voters punished the government in the local elections. The party is slumping in the opinion polls, having lost a third of its support in less than a year. Labour MPs are wondering what they signed up for. Many of them are entering parliament for the first time, scarred by 14 years of Conservative rule.

Anything that smacks of “austerity” must be repudiated. The welfare reforms at which so many of them baulked were only going to reduce the growth of disability spending, not cut it. That was a step too far for enough Labour MPs that the government could no longer rely on its majority.

Our analysis of each Labour MP showed that opposition to the welfare reforms extended well beyond the usual troublemakers. We ranked each MP by a number of quantitative criteria such as their voting record, incumbency and ministerial status to create a ranking for how likely they were to rebel. Even some of those with a relatively neutral score voted against the bill, such was the depth of opposition.

This is the start of an ongoing problem that will stymie the government’s agenda. The rebels succeeded and will now be emboldened. The left of the Labour Party is the political tail wagging the fiscal dog. Hence, there are renewed calls for the government to consider a wealth tax. As much as the gilt market is becalmed by the expectation of higher taxes plugging the fiscal gap, anything that dissuades capital and wealth from flowing into British assets would only serve to make the hole even bigger.

The latest Fiscal Risks and Sustainability report from the OBR has highlighted the dependence of the gilt market on the kindness of strangers. Overseas holders of gilts have become an increasing source of demand for the UK’s government debt. Their share of total gilt holdings has risen from 19% in 1998-1999 to 31% in 2023-2024.

If tax increases are thought to harm growth or hurt capital, foreign holders will need a higher yield or lower sterling to compensate them for the increased risk. All of this adds up to a winter of discontent for gilts. The Budget can’t be tough enough to please financial markets while being loose enough to please Labour MPs. The political and fiscal constraints upon the chancellor have combined to leave her in zugzwang, where no move confers an advantage upon her position. Swapping the pieces on the board won’t improve matters either. Les jeux sont faits.

Helen Thomas is the founder and CEO of Blonde Money, a macroeconomic consultancy.

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