The economics of a U-turn

Good morning from New Economy Brief,

Last week, the Labour Party took what has been described as the “mother of all U-turns”, and scrapped its flagship policy of spending £28 billion per year on green investment. The Green Prosperity Plan (GPP) has been seen by many as Keir Starmer’s flagship policy, the UK’s answer to the US’ Inflation Reduction Act and a potential antidote to stagnant growth. But as the scheme takes a massive financial hit, we explore why Labour has made this decision and whether the climbdown will be the vote-winner the party hopes it will be.

What was the policy and how has it changed? Back in September 2021, Labour’s Shadow Chancellor, Rachel Reeves, pledged to become the first “green chancellor”, investing £28 billion per year in green projects for the rest of the decade. However, in June 2023, citing a poor economic backdrop and high interest rates following the Truss and Kwarteng mini-budget, Reeves announced that Labour would delay the plans, sparking questions about how committed the party was to the policy. Following months of rumoured internal squabbles and pressure leading up to this year’s general election campaign, Labour finally ditched the £28 billion figure completely. The pledge has now dropped to £4.7 billion per year (that’s less over the course of the first parliament than their original pledge was over just a year). The new £4.7 billion figure is new money and is in addition to the £10 billion the government has already committed to for green projects. Labour has said that half of the new money would come from an increase in its plans for an oil and gas windfall tax (from 75% to 78%), and the other half from borrowing. 

• What’s left? Elements of the GPP have remained relatively unscathed, with a one-off £8.3 billion remaining for the creation of a state owned energy company (GB energy) and £7.3 billion for a national wealth fund to create green jobs. However, the Warm Homes Plan, which previously made up £6 billion per year of the original £28 billion, has been significantly reduced to £1.3 billion. As a result, the initial aim of retrofitting 19 million homes over five years has been reduced to a goal of five million. Much of the original £28bn figure was unallocated, so cutting it has not impacted on previously announced policies. 
• The impact. According to E3G, while insulating five million homes by 2030 would be an improvement on today’s “sluggish rates”, it may still not be enough to meet fuel poverty and heat decarbonation targets. Experts and campaigners are concerned that the rowback on retrofitting will prolong the cost of living crisis for vulnerable households. Mike Childs, the head of policy at Friends of the Earth, said Labour had “turned its back on the people who most urgently need these essential upgrades – the many millions of low-income households suffering from living in poorly insulated homes”. According to E3G, households living in the least efficient homes will pay around £916 more per year on energy bills, while the New Economics Foundation estimates that 1 in 4 pounds spent on heating is wasted.
• Does any of this matter? While the reaction to the u-turn has dominated the news, it is worth noting that the spending pledges made by an opposition party in the year before an election are only a rough guide to what will actually happen. As former SPAD Giles Wilkes points out: “Between now and 2028-9 there are about 10 new OBR forecasts, the planning and delivery of several trillion pounds of spending, many COPs and far more that can’t be predicted. No one in opposition can in good faith promise anything that far out”.

The fiscal context. That said, the economics behind this u-turn are worth unpicking. Keen to present itself as the party of fiscal responsibility ahead of this year’s general election, Labour cites a poor economic outlook and the high cost of borrowing as reasons for the climbdown. The party has also attacked the Chancellor for using up the ‘headroom’ against his fiscal rules, leaving Labour with less room for manoeuvre. Indeed, Starmer said that it was due to the Chancellor’s plans to “‘max out’ the country’s credit card” that Labour couldn’t commit to the £28 billion (a metaphor deemed “dangerous” in the 2022 BBC impartiality review on fiscal policy). 

• Choices and consequences: While it is certainly true that borrowing costs have risen since 2021, this argument from Labour obscures the extent to which their own choices have driven this reversal. Firstly, the Chancellor cannot ‘use up’ the headroom for Labour with tax cuts unless Labour promises to match those tax cuts. This is a choice, not an inevitability. Secondly, committing to a 5 year debt target as a fiscal rule (which Labour appear to have done, though they have not set out their fiscal rules in detail) is a choice. It is perfectly normal and reasonable to adopt different fiscal rules, especially given that the government has changed theirs so frequently.
• Gaming the rules The role of the 5 year debt target - the most significant fiscal rule - bears more scrutiny here. Under this rule, the government’s debt to GDP ratio must be falling in the 5th year of the forecast period. There are many criticisms of this rule and its primacy in determining fiscal credibility. One is that the rule can be easily gamed in two ways. As this government is proving, as long as the ratio is lower in the 5th year than it is in the the 4th year then the rule is met, regardless of how much debt is accrued in the meantime (this is the subject of Chief Secretary to the Treasury Laura Trott’s recent car crash interview with Evan Davies). In addition, the rules can be effectively gamed by pencilling in unrealistic future spending plans- again this is what this government has been accused of doing.
• Entrenched short-termism? But the fact that it can be gamed is not the only criticism of this fiscal rule. For these purposes the key points about this rule are that it does not distinguish between investment and day-to-day spending and that it has a 5 year time horizon. This means that any benefits of government spending that accrue after this horizon will not count against this rule. Given that most government investment has a longer pay-off time, the rule effectively discourages investment spending, even on projects which would improve fiscal sustainability over the longer term (as the policies in the Green Prosperity Plan almost certainly would). As Oxford economist Simon Wren Lewis argues “the falling debt to GDP fiscal rule could reasonably be called the ‘reduce public investment’ rule”. Arguably this u-turn proves Wren Lewis’ point.
• Rules of the game. Labour’s fiscal rules have long been a rhetorical prop for the party but this saga is one of the first instances in which their consequences have been evident. In the lead up to the u-turn Keir Starmer’s usual response when pressed about the figure was that it would be “subject to fiscal rules”. This is to some extent a tautology; by their very existence fiscal rules imply that all policies are subject to them. However, once this had been set out, it is unclear from an economic policy standpoint why a further reduction of the number was necessary. If the policy is subject to the fiscal rules, then by definition Labour would only spend as much on the policy as was consistent with their debt target. If the fiscal rules are the guarantors of fiscal rectitude, then why was a further retreat necessary?

Reducing the target. The answer is the politics. Received wisdom would tell us that voters are wary of government borrowing and large government debt. And given that 2024 is an election year, this has no doubt been a huge factor in Labour’s decision. The temptation to remove the big £28bn number and reduce the target for the Conservatives to attack appears to have won out (although, as the Financial Times’ Stephen Bush points out, they will still have the ‘problem’ of defending borrowing, and it is not clear that the public will react differently to £11bn of borrowing then they would to £28bn). 

A smart political choice? But is defending borrowing a problem? According to new research conducted by polling expert Steve Akehurst with YouGov and the Economic Change Unit, public opinion on the issues of borrowing and investment is more nuanced than many people suggest. While voters do retain some scepticism about government borrowing, Akehurst argues that it is clear that the balance of priorities has shifted in favour of increasing spending on the NHS, renewable energy production, transport infrastructure and housing infrastructure, even if it involves borrowing. The polling also showed that voters would overwhelmingly prefer to vote for a party that “increased government investment in the economy to stimulate economic growth, even if it meant government debt rising in the short term”, rather than a party “that reduced government debt in the short term, even if it meant less investment in the economy in the short term”. Voters may not love the idea of borrowing (and credit card metaphors certainly won’t help that case) but in the face of cold, poorly-insulated homes, poor growth and growing climate anxiety, could it be that Labour have picked the wrong battle?