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Sir Keir Starmer has warned Labour MPs that Britain’s fiscal rules will not be relaxed to avert painful welfare cuts, in spite of growing party pressure for the UK to follow Germany in turning on the borrowing taps.
The prime minister has agreed with chancellor Rachel Reeves that Britain’s fiscal rules must be respected and that any relaxation of the self-imposed restriction would spook markets and force up borrowing costs.
“The markets are still testing us,” said one senior government official. “We are in a situation where the decisions we make are coming under considerable scrutiny.”
Germany’s decision to loosen its borrowing rules to fund a spending spree on defence and infrastructure projects has increased pressure on Reeves to look again at her rules, which require her to balance current spending with tax receipts by 2029-30.
Anneliese Dodds, who quit as overseas development minister last month over cuts to the aid budget, told Starmer in her resignation letter that she “expected we would collectively discuss our fiscal rules and approach to taxation, as other nations are doing”.
John McDonnell, former shadow chancellor, told the Financial Times the rules “have to be relaxed”. He said Reeves’ rules were requiring her to cut more from the welfare bill than the Conservatives had planned. Savings of up to £6bn a year have been mooted.
Other mainstream Labour MPs, many of whom have been invited into Downing Street in recent days to be briefed on the planned welfare cuts, say discussion of the fiscal rules inside the party is widespread.
One said: “Cutting welfare is tough for Labour MPs, the toughest thing we’ve been asked to swallow. Talk about relaxing the fiscal rules is bubbling under and is about to break the surface.”
Another Labour MP said: “When the situation changes, then you can’t just stick to your previous plans, you need to look at things like higher taxes or your fiscal rules.”
Richard Burgon, a former Labour frontbencher, this week used a question in Prime Minister’s Questions to say that a “wealth tax” should replace planned welfare cuts.
It is common in British politics for the prime minister of the day to side with MPs who want more spending, leading to tensions with the chancellor. On the question of fiscal discipline, however, Starmer and Reeves appear aligned.
One ally of Starmer said that if Britain followed Germany in relaxing its fiscal rules, the subsequent rise in UK borrowing costs imposed by the markets would be punishing.
One said: “Germany has a debt-to-GDP ratio of 62 per cent while ours is about 95 per cent. There are obvious differences there.”
Reeves has said her fiscal rules are “non negotiable” and ordered a cut in the aid budget to fund an increase in defence spending from 2.3 per cent of GDP to 2.5 per cent in 2027.
Germany’s incoming government has proposed a €500bn fund for infrastructure and changes to borrowing rules to allow a wave of rearmament spending. The announcement triggered the biggest one-day rise in its borrowing costs since 1997 last week as investors braced themselves for a surge in debt issuance.
Joachim Nagel, the head of the Deutsche Bundesbank, told the BBC on Thursday it was an “extraordinary measure” for an “extraordinary time”.
Economists believe that Reeves’ plan for the public finances has been blown off course by a combination of rising borrowing costs and slow growth, and some expect her to cut spending or raise taxes by at least £10bn in her Spring Statement on March 26.
In October she allowed herself £9.9bn of headroom against her fiscal rule but that is thought to have been wiped out. Welfare cuts and other spending reductions are being planned to provide the chancellor with a cushion against further bad news.
Nicolas Trindade, a senior portfolio manager at Axa’s investment management arm, warned that Reeves “cannot keep on managing the economy with just £10bn of headroom”, adding: “It just doesn’t work and she is just going to have the same issue over and over again.”
Any move to loosen fiscal rules that were changed as recently as October would be poorly received by the market, investors said. Concerns about higher UK borrowing combined with a global bond sell-off to take UK 10-year borrowing costs to a 16-year high at 4.93 per cent in January.
At slightly less than 4.7 per cent on Thursday, they remain almost a percentage point above where they were in mid-September, and at levels comparable with those reached at the height of the market crisis following the ill-fated 2022 “mini” Budget.
“The UK Treasury is caught in a bind,” said James Smith, UK economist at ING. “Higher debt interest costs mean painful spending cuts at the Spring Statement on 26 March now look inevitable. And further tax rises look increasingly likely later in the year.”
