Iran has killed off Reeves’s fiscal rules. Here’s how to radically rewrite them

Because much of our economic architecture – from central bank inflation targeting, to globalised production lines to the destruction of trade union power – was erected as the solution to stagflation.

The oil price spike that followed the Arab-Israeli war in 1973 killed the Keynesian economic model and replaced it – after a second round of pain in 1979 – with the neoliberal one we’ve suffered for more than 40 years. Now, unless this gets sorted quickly, we are looking once again at global economic regime change. Because the solution has itself become the problem.

In light of that, any idea that Rachel Reeves’ fiscal rules can or should survive is ludicrous. In this new world, not only will the Treasury’s self-imposed targets come under stress, but the entire fiscal and monetary regime the UK has followed since the late 1990s.

And though the entire west faces the same problem, we – as the G7 country paying the most for government borrowing – will face it most acutely. Though the Starmer government has handled the geopolitics deftly – staying out of the war while rationing US access to British bases – how it handles the economics will be make or break.

Let’s reprise the basics. Self-imposed rules on borrowing are there to create credibility with the people who lend to government: British pension funds, banks and hedge funds, their foreign counterparts, plus foreign central banks.

What you’re trying to do is reduce the amount of interest those lenders charge, which is known as the gilt yield. Three things influence those yields: the supply of and demand for debt, expectations of inflation, and whether borrowing looks under control.

The UK is problematic because the supply of government debt has started to exceed demand; because we are an inflation-prone economy; because we’ve responded to repeated economic shocks by hiking debt close to 100% of GDP; and because Liz Truss tried to scam her way out of the problem.

Reeves set the latest fiscal rules in July 2024 to underpin her policy of investment-led growth. And they were sensible. She changed the debt-to-GDP measure from a crude to a more sophisticated one ; she pledged to bring day-to-day spending in line with tax receipts; to borrow only to invest; and to have debt falling as a percentage of GDP by 2029. 

Crucially, her rules state that after 2029 debt must go on falling by the end of every three-year forecast. But if the Iran war leads to a long upsurge in prices, together with an economic slump, those rules are toast – and the culture secretary Lisa Nandy was right to warn about that in a Cabinet meeting last week.

The conventional view is that the UK’s borrowing costs are higher than for other G7 countries because the Truss fiasco damaged lenders’ confidence, and because Labour’s backbench revolt over welfare reform raised fears that the government that will try to spend its way out of unpopularity, if Keir Starmer is deposed.

But high gilt yields are not an inevitability, they are a choice. Whether it’s a stolid British pension fund or a shadowy Geneva hedge fund, financial institutions buy government bonds because they are the safest form of investment on earth. And though bond buyers have the power to shape the cost of borrowing, so do governments. 

But the UK’s fiscal and monetary regime looks badly designed to exert that power. 

First, the structure of the bond market is changing rapidly. With the decline of “defined benefit” pension schemes, demand for long-dated gilts is falling; defined contribution schemes – where payouts vary according to stock market performance – hold only 7% of their money in gilts. 

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But while demand for long-dated UK debt is in decline, the Debt Management Office – the government body that issues the debt – has a bias towards borrowing in this form. The reason is that the UK government traditionally prefers to pay a higher interest rate up front than bear the risks of having to roll over debts that mature earlier.

So the DMO is issuing debt of a kind the market increasingly does not want. And though it began a switch towards shorter-dated debt last year, this may have to happen faster.

To compound the problem, the Bank of England is dumping the same kind of long-dated debt into the market, through a process called Quantitative Tightening – selling off the bonds it bought during the financial crisis.

Finally, the Office for Budget Responsibility compounds matters by repeatedly refusing to recognise that Reeves’ economic strategy might work. Its neanderthal, Thatcherite economists don’t believe in investment-led growth, and they say so loudly in the run up to every Budget, forcing the government into over-cautious spending plans.

There is a solution. It sounds radical. But not as radical as the total economic rethink that Western economies went through in the late 1970s after the last stagflation shock. 

First, the government needs a fiscal watchdog that believes in the basic capitalist principle that investment can drive growth. Either the OBR’s leadership and remit should be changed, or the body itself scrapped. There will be negative market reactions in the short term, but they are worth enduring to escape the trap we’re in.

Second, the UK needs to rethink the structure of its debt issuance, altering the mix of maturities towards shorter-duration debt to match what lenders want. 

Third, it needs to instruct the Bank of England to end Quantitative Tightening and get ready, once again, to do Quantitative Easing – because if we face a slump, it is likely we also face a second global financial crisis. I don’t care how this instruction is sent: a letter to the governor, an eyebrow raised over lunch, or an act of parliament: we’ve simply got to end QT right now.

Fourth, Reeves should suspend the fiscal rule that imposes a three-year rolling debt reduction target. In a period of war and stagflation it’s just not going to happen.

Finally, we should acknowledge the likelihood that – just as in the post-war era – the debt pile will be reduced through inflation. Not a spike, but a steady, higher figure than the 2% currently targeted. Because if the Bank of England responds to an externally generated inflation spike with rate rises, it will – once again – tank the economy.

Economists call reducing debt through inflation “financial repression” – because it means savers are forced to hold government bonds even as price rises erode their value. And it sounds terrible, until you glance at all those local nostalgia pages on Facebook and realise that the years of “financial repression” – from the 1950s to the 1970s – were the most prosperous era in history.

The dilemma we face is not an accident. America is trying to dump the costs of a stagnating global economy onto the rest of the world. Globalisation is over. Wars are proliferating.

And in the face of that the old models – fiscal rules, inflation targeting – are no longer sufficient. The core of the government’s strategy – borrowing to invest, rearmament and the switch from low to high value work – remains correct. But we’re going to need a new policy architecture to survive. 

So even if the Iran problem suddenly subsides, this is a wakeup call – because in a world ruled by deranged authoritarians there will be plenty more shocks in future.

Paul Mason’s new book Reds: A Global History of Communism is published in August