Can Reeves get away with changing the rules on government borrowing?

After the chancellor announced her discovery of the ‘black hole’ at the heart of the public finances, Sean O’Grady examines one of the measures she might put in place to get things back on track

Any suggestion that the chancellor is bending the rules would damage her credibility (PA)

Rachel Reeves certainly looked very cross when she gravely told the House of Commons the other day that she’d discovered the now infamous “black hole” in the public finances for the current year. It’s certainly true that at least some of that deficit is down to a genuine political choice made by Reeves and the government – the pay boost for teachers coming in at £9bn (or £6bn after efficiency savings), for example.

Still, it means that the chancellor is having to make some painful public spending cuts (including means-testing the previously universal winter fuel allowance), amounting to £5.5bn for the 2024-25 financial year and rising to £8.1bn in 2025-26. That leaves more to be funded from raising taxes (for instance, capital gains tax). A third option, and arguably a less problematic one, would be simply to amend the precise details of the rules on government borrowing. This is now the subject of some debate...

What could Reeves do?

The idea currently being discussed in fashionable circles is to take the Bank of England’s operations out of the definition of public borrowing that is currently in use. This is a highly technical subject, but some economists argue that it could create an extra £17bn of “wriggle room” in the current fiscal year. That would take a lot of the pressure off Reeves as she approaches her first, defining Budget on 30 October.

Surely it can’t be that simple?

Yes and no. As we remember, the Bank of England created lots of easy money on ultra-low interest rates during the global financial crisis in 2008, and again on an even bigger scale during the pandemic. This was referred to as “quantitative easing”, because it bloated the quantity of money swirling around in the economy, and eased the cost of borrowing it.

The Bank did this by creating and buying government bonds, and creating the money to do so. It was indemnified by the Treasury for any losses it would make on (eventually) selling the billions of pounds of government bonds it had accumulated – and the profits made during the pandemic, which were substantial, were passed to the Treasury.

In reality, the Bank had to do that or go bust, and, given that it’s owned by the Treasury, the decision was really a formality. It amounted to the Bank (willingly) agreeing to implement government policy during two emergencies. But now that the emergencies have passed, and interest rates are much higher, the bonds are worth less, and this means the Treasury has to cover the Bank’s losses – by borrowing and creating fresh debt. The more bonds the Bank sells, the more money the Treasury has to find to offset the losses it makes when it offloads them onto the market.

Reversing QE is called quantitative tightening, or QT.

So the Treasury will be borrowing more money?

Yes, if the Bank sells the bonds in line with its strategy to offload them and tighten the money supply, commensurate with keeping the commercial banks stable – so the process is now called quantitative tightening. It’s all borrowing, but not all government borrowing is equal. Some is counted towards the fiscal targets, and some is excluded from the fiscal targets. The borrowing is still going on, but the accounting of the detailed, precise definition of the target is different – which is, as it happens, very helpful to a government that is struggling to balance its books.

Does it matter?

Economically, less than it appears, and for a few reasons. First, although the cost to the taxpayer of unwinding QE is in theory incredibly high – between £50bn and £130bn could be lost over the lifetime of the programme – this can be managed over a very long time frame. Indeed, the Bank wouldn’t have much of a problem in pausing QT for a considerable if not indefinite period; its governor, Andrew Bailey, has suggested that it helps to keep the commercial banks healthy and makes monetary policy more effective.

Second, the potential extra borrowing available to Reeves – the £17bn or so – is a tiny sum when set against the total national debt of around £2,700bn. Third, if growth picks up a little better than expected, it will get “lost” in the debt-to-GDP ratio anyway (although there is now talk of a US and global slowdown, which will make things even harder for Reeves).

And politically?

As we’ve seen in successive elections, tax has always been a sensitive issue for Labour, as has fiscal credibility, and any suggestion that Reeves is bending the rules would damage her credibility. It is the kind of ruse that chancellors of both parties find hard to resist, but it would certainly go against her “iron-clad” determination to stick to the rules.

As she herself said in her Mais lecture in March: “The UK has changed its fiscal rules more frequently than any other OECD economy, with the average lifespan of less than four years. That has contributed to instability and uncertainty. So I will end the practice of the chancellor being able to scrap the rules at any time, with an escape clause that would only suspend the rules if the OBR declared the UK was in an economic crisis.”

Those defiant words may come back to haunt her, but the saving grace is that the treatment of central-bank losses in the public finances is so arcane that the average voter will find it hard to get worked up about the issue. It’s not the sort of thing that comes up in the polling, and it’s unlikely to drive mortgage rates.

In any case, despite the fuss, the “black hole” is manageable – and with luck, or rather, higher growth, it could soon disappear. And it is growth, not fiscal rules, that will be the making or breaking of this administration.

Could Reeves get away with it?

She’d love to, and at this point in the electoral cycle she probably would. It is not as if the Tories can boast about their recent record, after all.