Broken Britain: can a Labour government fix it?

Keir Starmer’s suited and rebooted Labour Party looks set to sweep to power and says it is ready for business. But Labour will also inherit an economy suffering from a chronic lack of growth, a housing crisis, and failing public services. Nothing seems to be working properly and productivity has stagnated. Can Labour get the economy moving again?

One point in Labour’s favour is simply the chance to make a fresh start. Investors crave political stability and a centrist government with a large majority should deliver that. Indeed, UK bonds, equities and the pound are already starting to benefit as “safe havens” from the electoral risks in other European countries, notably France and the US. The UK might now have a prime minister, a chancellor, and even a housing minister who remain in their posts for a full five years.

Another tailwind is that the economic prospects for this year and next have already brightened considerably. The Conservatives could have fought an election in the autumn against the backdrop of two quarters of decent economic growth, several months of inflation at or below the 2% target, and at least one interest-rate cut from the Bank of England.

In the meantime, confidence is gradually returning to the financial markets, to businesses and, most importantly, to consumers. Rishi Sunak and Jeremy Hunt deserve credit for putting the train back on the tracks. But an incoming Labour government will now reap the benefits.

The performance of the economy over the 14 years of Conservative government has still been poor. The headline numbers may look reasonable – since 2010 the UK has recorded the third-highest growth rate of all the G7 group of major economies, behind only Canada and the US, and outpacing Germany and France.

However, adjusting for the increase in the UK population, average annual growth in GDP per head has been the weakest under any government since 1945. After taking account of inflation, real wages have barely grown at all.

The root of this problem is the weakness in productivity, which measures how efficiently inputs such as labour and capital are used to produce a given amount of output. Since 2010, output per hour worked in the UK has grown at roughly half the rates of Germany and Japan, as well as Canada and the US.

It is unfair to pin all the blame on the Conservatives. The rot set in in the wake of the global financial crisis (GFC) of 2008, under Labour’s watch. Productivity growth has also dropped off sharply in most major economies. But the suffering of others is no consolation. UK output per hour would now be at least 20% higher if productivity had continued to grow at its pre-GFC rate. This problem becomes even clearer if you think of that as a 20% shortfall in living standards.

Moreover, weak productivity and sluggish growth have made it harder to deal with social challenges, such as reducing poverty and tackling climate change, and to raise the tax revenues needed to meet growing demands on public services. The legacy of the long period of poor economic performance has included a sharp rise in government 5 July 2024 debt, which has risen from 65% of national income in 2020 to nearly 100% now.

Naturally, if you ask two economists to explain this “productivity puzzle” you’ll hear at least three different answers. Some think the slowdown in productivity and economic growth might be structural and long-lasting. They blame factors such as diminishing returns from the digital revolution and the increasing environmental and demographic constraints.

Others give more weight to economic shocks, notably Covid and the energy crisis. Again, the Conservatives are not to blame for these events. But the government of the day must take responsibility for any policy errors. Depending on your point of view, these mistakes might include the poor handling of Brexit, or leaving the EU at all, as well as the responses to Covid and the approach to “net zero”.

The Bank of England is not above criticism either. The extended period of low interest rates kept many relatively unproductive firms afloat, while money printing under the policy of “quantitative easing” provided the fuel for the surge in inflation.

But most commentators agree that one of the UK’s biggest problems is the relatively low levels of investment – both public and private – in everything from infrastructure and housing to technology and skills.

Here, the Conservatives and Labour part ways again. The Conservatives fought the election on a promise to reduce the size of the state, with tax cuts financed by efficiency savings and a reduction in the welfare bill, and with a renewed focus on deregulation. The emphasis was on creating the conditions under which the private sector can thrive, then letting businesses and households crack on with the minimum of interference from the state.

Labour proposes a more active role for the government. In part this is a revolt against the “austerity” under the Conservatives that aimed to reduce government borrowing through a combination of spending restraint and tax increases. But many fear this is about to make a comeback, whoever wins the election.

The coalition years between 2010 and 2015 in particular are sometimes described as a period of “savage cuts”. This language is over the top. In reality, the overall amount of day-to-day spending essentially kept pace with inflation, and spending on the NHS and schools continued to grow in real terms. Nonetheless, some departmental budgets did suffer substantial cuts, especially in capital spending.

Moreover, the increases in spending on health and education failed to match the rise in the numbers of patients and pupils. Demographics presents a further challenge. UK government spending on healthcare was broadly stable as a share of national income during the 2010s. However, this ratio increased by about half a percentage point in the 2010s in Germany and in France, and by nearly two percentage points in Japan, to meet the demands of an ageing population.

This prompts the question of why on Earth anyone thought austerity was a good idea. The official view at the time, both in the UK and elsewhere, was that it was necessary to tighten fiscal policy, even at the cost of a weaker economic recovery, in order to prevent an even worse outcome. UK politicians and officials were particularly worried by the financial crisis then beginning to engulf Greece. And they believed that the economic drag would at least be partly offset by an increase in private spending, as tight control of public spending kept interest rates low and prevented “crowding out”.

Supporters of austerity can also point to the apparent success of the policy in stabilising the ratio of public debt to national income at around 80% by the second half of the 2010s, before another jump in the wake of Covid.

But most economists now think that austerity was a mistake. Instead, the government should have exploited low interest rates to increase spending, both to provide an immediate boost to demand and to increase investment for the longer term.

Critics of austerity have also noted that the international creditworthiness of the UK was never seriously in doubt. Unlike Greece, the UK was not a member of the euro and therefore retained its independence on monetary policy and the ability to create money to service debts.

Looking back, it is impossible to be certain what would have happened without the tight control of spending. Opponents of austerity might argue that a more expansionary policy could have boosted growth and therefore lowered the ratio of debt to GDP more quickly. Supporters might counter that interest rates would not have remained so low if fiscal policy had been loosened instead, and that simply pumping more cash into unreformed and inefficient public services would not have delivered much better outcomes.

But it is not unreasonable to argue that austerity hollowed out the state to such an extent that large parts of it, including many public services, are now barely functioning. The NHS and social-care systems were ill-prepared for Covid, while underinvestment in alternative energy sources left the UK especially exposed to the fallout from Putin’s invasion of Ukraine.

It is also hard to disagree with the argument that the state underinvested during this period in “public goods” that cannot be left to private markets, such as flood defences, the military, and the criminal justice system, and in other critical infrastructure projects, such as reservoirs, the transport network, and nuclear energy.

The big question, though, is can Labour do any better? Labour has prioritised boosting productivity, with the aim of securing the highest sustainable growth rate of any major economy. It is not clear how this would be done.

But Labour’s manifesto does at least set out the broad principles: delivering economic stability with tough spending rules; a new partnership with business to boost growth everywhere; a National Wealth Fund to invest in jobs; planning reform to build 1.5 million new homes; devolution of power across England; and a New Deal for Working People.

Labour’s would-be chancellor, Rachel Reeves, has promoted a new approach to economics: “securonomics”. According to the manifesto, this “will depend on a dynamic and strategic state. This does not mean ever-growing government, but it does mean a more active, smarter government that works in partnership with business, trade unions, local leaders, and devolved governments”.

This leaves a great many questions unanswered. The first, and most immediate, is where will the money come from, especially for increased investment in public services. Rachel Reeves has doubled down on the existing fiscal and monetary framework, including the rules on government debt, leaving little room for higher spending without higher taxes.

The current plans assume that total spending will grow by 1% a year in real terms, which could easily be swallowed up by healthcare and defence, implying deep cuts in other budgets, such as the Home Office. Sounds familiar? This could be austerity all over again. Indeed, with interest rates back to more normal levels and debt now much higher, the original economic case for austerity is just a little bit stronger.

It is therefore hard for any party to rule out tax rises. The Conservatives proposed to solve this conundrum by boosting productivity in public services, and by savings on the welfare bill. But it may be even harder for Labour given the extra pressure for more spending from the party’s core supporters and their greater willingness to see taxes rises to pay for it (on the assumption, of course, that those taxes are paid by other people).

Labour has said it will not be necessary to raise taxes to pay for the additional measures in the manifesto, aside from the tax increases already announced (which include extending the “windfall tax” on energy firms, imposing VAT on private school fees, and a further tightening of non-dom tax). Labour has also ruled out any increases to the main rates of personal income tax, national insurance, VAT, and corporation tax.

However, this still leaves plenty of scope for raising more revenue in other ways. It is easy to imagine a scenario where the new chancellor says that the public finances are in a worse state than she had anticipated. This would be a bit of a cop-out, but a newly elected government with a large majority may be able to get away with blaming the last lot.

Labour’s promise not to raise taxes on “working people” is pretty meaningless too. It could just be interpreted as a commitment not to raise taxes on income from employment. But in practice, many working people also pay tax on income from capital or savings.

It is important also to look beyond where the initial impact of a tax lands. A large increase in capital taxes that, for example, hammers investment and jobs, would also have knock on effects on working people.

Obvious early targets include an increase in capital gains tax on second homes and closing some of the loopholes in inheritance tax. But this might only raise another ￡10bn, meaning Labour would be unlikely to stop here.

The second set of questions concerns Labour’s relationship with business. There is plenty of talk about a new “strategic partnership”. But it is uncertain how this (and the National Wealth Fund in particular) would differ from the failed “industrial strategies” of the past, where successive governments tried and failed to pick winners worthy of taxpayers’ support.

The state may perhaps have some role to play in supporting the pure science that can lead to new inventions. But when it comes to creating commercial applications, or the diffusion of these innovations, there is ample proof that markets are more effective than government planning. Labour has also promised to improve on the Brexit deal. But the Conservatives are moving in this direction as well, while still starting to exploit the benefits of leaving the single market and customs union (yes, there are many).

There is plenty of talk too about a wave of private investment ready and waiting to boost the economy, especially for spending on infrastructure. But it is uncertain how this would differ from the old “Private Finance Initiative”, where taxpayers ended up paying higher interest rates and bearing more risk just for the sake of keeping debt off the government’s books.

Thirdly, and related to this, how will Labour be able to balance its relationships with businesses with its relationships with the trade unions? Labour’s New Deal for Working People will make the jobs market less flexible and increase the burdens on employers. The unions may also feel emboldened to resist the reforms that are needed to boost productivity in the public sector.

The fourth big issue is the cost of energy. British households are already paying just about the highest prices for electricity in Europe. But Labour’s unrealistic plans to decarbonise UK power by 2030 will load more costs onto consumers, businesses, and taxpayers.

Finally, Labour will have to be a lot more successful than the Tories in overcoming the “not in my back yard” (nimbyism) attitude that has long frustrated planning reform and held back infrastructure spending and house building. Sadiq Khan’s miserable record on housing as London’s Labour mayor is not encouraging.

However, there are good reasons to be optimistic. A commanding parliamentary majority should help Labour to overcome any political resistance. Labour’s strong support among younger, urban voters desperate for affordable housing is a plus too.

Above all, Labour appears to have made house building its top priority for the first weeks of the new government, including a plan to kick-start local reviews of “green-belt” boundaries. This is something that the Conservatives have been unable to deliver. But independent research suggests that allowing more building on just 1% of the green belt could get Labour halfway towards its target of 1.5 million new homes over five years.

There are reasons for scepticism as well. In particular, it is hard to square a national target for house building with Labour’s plan to devolve more power to local authorities. The plan also relies on front-loading the spending on infrastructure to support an influx of new residents, again prompting the question of where the money will come from.

Getting Britain building again could be the biggest single achievement of a new Labour government. There is still a lot else that could disrupt the economy and undermine productivity. But it is easy to see why so many voters are willing to give Labour a chance.

This essay was first published in MoneyWeek on 5 July 2024