Economic challenges facing the new prime minister
Following Sir Keir Starmer’s resignation as prime minister last week, the Labour Party is electing a new leader, who would be the seventh prime minister in 10 years. The timetable set by Labour's governing body means we will only know by the 15th of July whether there is more than one contender for the job. Regardless, it is widely expected that Andy Burnham, the former mayor of Greater Manchester and now an MP, will succeed Sir Keir Starmer.
We are likely to hear more about Mr Burnham’s policy agenda over the coming weeks. He is expected to make a speech in Manchester today sharing his economic vision. Given a new prime minister would look to reset policy priorities, it is worth considering some of the major economic and fiscal challenges they will have to grapple with.
Public spending
Forecast to hover around 45% of GDP for the rest of this decade, government spending has never been higher outside of economic crises or wartime. Yet satisfaction with public services remains low. Take the National Health Service (NHS) for example. Survey data show that public satisfaction with the NHS is close to its lowest level since the early 80s.
And the demands of the state are set to grow. An ageing population will push up expenditure on pensions, healthcare and adult social care while elevated geopolitical risk necessitates higher spending on defence. The biggest challenge for a new prime minister will be articulating what the state can realistically offer, to the public's satisfaction, given the growing asks of it.
Any unwinding of spending commitments won't be easy, as Sir Keir Starmer's recent efforts have shown. Backbench opposition forced him to reverse course when attempting to reduce disability-related benefits and on plans to reform the winter fuel allowance by introducing means testing in 2024. In fact, spending has been driven higher, in part, by greater welfare commitments, through his tenure as prime minister.
It is too early to assess what Mr Burnham's policy instincts will mean for public expenditure. At a recent event, he promised to bring down utility bills and rail fares for consumers, which will likely necessitate higher spending. But he has also suggested he would reduce welfare spend on working-age people through employment support schemes (rather than benefit cuts). His choice of Chancellor, whether on the party's soft-left or a centrist, will likely be a key indicator of his ambitions for the size of the state.
Debt & borrowing
There is limited scope to borrow in support of spending. Government debt as a share of GDP has risen sharply since the pandemic. The government's borrowing costs have also spiked, with debt interest payments expected to cost the government more than its entire budget on education this year. Bond investors now demand a higher rate of interest from Britain than any of its G7 peers and are quick to respond to any hint of extravagance.
As a result, Mr Burnham has committed to sticking to the fiscal rules set out by the current Chancellor Rachel Reeves, which include ensuring that net debt is falling as a share of GDP in three years' time. Baron Jim O'Neill, a prominent economist and former minister advising Mr Burnham, has argued that the existing fiscal rules might allow for additional borrowing - specifically to invest in infrastructure through a newly created independent body. While there remains some scope for borrowing to invest, markets are likely to scrutinise how targeted and growth-enhancing the intervention is, and the trajectory of public spending alongside it. As Andy Haldane, former chief economist of the Bank of England and another advisor to Mr Burnham, said last week - "demonstrating a willingness and ability to keep control over public spending is the thing that markets, above all else, need to see".
Taxation, devolution and public control of utilities
With political constraints on cutting spending and financial limits to greater borrowing, any expensive policy measures may ultimately require tax increases. But the tax burden is set to reach its highest level since the 1940s. Last month, the IMF warned that, without fundamental tax reform, the UK’s scope for further tax rises over the long term was “becoming limited”.
Indeed, the UK's total tax take now sits just above the OECD's average and further increases would need to account for their impact on competitiveness. Data show that when it comes to taxing top earners, the UK is middle of the pack among OECD countries. But for middle-income earners, the effective tax rate remains well below the OECD average.
Mr Burnham has promised to stick to the Labour party’s 2024 manifesto pledge not to raise the rate of VAT, employee NI and income tax, which account for the bulk of government revenues. This limits room for manoeuvre, but his team is said to be examining potential reforms to property taxes, changing the tax treatment of capital gains, replacing the existing inheritance tax with a social care levy and business rates relief for small businesses.
Aside from policies on taxation and spending, Mr Burnham is also supportive of greater "public control" of essential services and devolving power to the regions. On the former, his team have yet to set out the extent of change they envisage in this parliament but the government's ability to buy back assets and fund investment will also depend on the external financing environment. On the latter, economic evidence is generally favourable and there is already a Treasury review on fiscal devolution underway. Mr Burnham could provide greater impetus to it and also push towards devolving oversight and funding for public service departments.
Domestic economy
A new prime minister will also inherit a challenging external environment, marked by elevated geopolitical uncertainty, and a domestic backdrop featuring sub-par growth, rising inflation and a softening labour market. Faster growth will undoubtedly be a priority but, given the number of exogenous factors that could influence it, delivering it is no mean feat. The standard prescription for a weakening economy is investment - into energy, transport, housing and education - to boost its productive capacity. The payoff for these investments typically accrues over the medium term but the costs are immediate.
One advantage facing the next prime minister is the opportunity presented by artificial intelligence. The UK is well positioned, given its strong research base, highly developed services sector and skilled workforce. Harnessing its full potential - by expanding investment in research, world class AI infrastructure, AI skills and talent, and accelerating adoption and new job creation through the creation of regional clusters - may yield productivity benefits sooner rather than later.
In addition, as Mr Haldane points out, there remain options for the government to support growth at "close to no fiscal cost", such as simplifying the UK's "stupendously complex" tax code and "cutting back on the thicket of regulation". These recommendations aren't new and deregulation has been a priority for Sir Keir Starmer. But internal party divisions made progress slow. A new prime minister will likely have the political room to make some quick decisions on these fronts.
Crucially, to sustainably lift growth, businesses and households require a level of stability and predictability, after a succession of shocks. This will be in the prime minister's gift. Setting out a clear vision for growth and a stable policy framework could go a long way towards encouraging firms to invest, innovate, and expand, while giving households greater confidence to spend.
But the new government will have to move quickly. As Sir Keir Starmer's experience shows, it is one thing to diagnose what ails the UK economy. Administering the policy prescription to fix it quite another.
Chart of the week
The last three years saw nominal wage growth outpace inflation, resulting in a long period of real wage rises for UK consumers. This was a welcome reversal from the squeeze on real wages seen in 2022 and the first half of 2023, as energy prices and inflation spiked following Russia's invasion of Ukraine.
But, as nominal wages slow and the war in Iran pushes inflation higher, we expect real wage growth to turn negative in the second half of this year. This is likely to dampen consumer sentiment and further delay a broad-based recovery in household spending.
However, with inflation set to fall through 2027 towards the Bank of England's 2% target, real wages should recover in the second half of next year.
What we're looking out for this week?
This week, we will be looking out for the US jobs report on Thursday, which is a key indicator of the strength of the American economy. Job growth has remained unexpectedly resilient in recent months, with over 500,000 jobs created between March and May, albeit concentrated in a handful of sectors.
Economists expect slower, but still healthy, payrolls growth in June. A better-than-expected reading will suggest relative resilience, especially if job growth is seen to be spreading out across the economy. That will add to expectations of monetary tightening.
And finally...
Earlier this month, the Pentagon released another set of files on what the US government knows about alien life. The documents do not confirm the existence of non-earthly creatures, but do reveal details about recent alleged sightings, including one of a potato-shaped entity – unidentified frying object